Chapter 10
Default Probability, Credit Spreads and Credit Derivatives
So far, this book has been largely concerned with credit exposure, the market risk component of counterparty risk. Now we focus on the credit risk component arising from the probability of counterparty default and the loss incurred as a result. We will also discuss recovery rates, which define the amount of a claim that is received from a defaulted counterparty.
Default probability plays a critical role in counterparty risk assessment and valuation (CVA). There are different ways to define default probability which we will explain, noting the important difference between using real-world (e.g., historical data) and risk-neutral probabilities (market data). In the latter case, we consider mapping methods that may be used for estimating the credit spread of a counterparty where this cannot be estimated directly. We also consider the term structure of default probability (how default probability changes over time) and show that this is an important consideration. The empirical relationship between real-world and risk-neutral default probabilities (a very important point for defining CVA) is discussed.
Finally, we will examine single-name and portfolio credit derivative products, which are important for hedging purposes (Chapter 16) and the consideration of wrong-way risk (Chapter 15).
