Risk Management: Foundations for a Changing Financial World

CHAPTER 28

CREDIT RISK^ab

Jeremy Graveline and Michael Kokalari

This review provides a comprehensive survey of recent quantitative research on the pricing of credit risk. It also explores two types of models commonly used for pricing credit risk—structural models and reduced-form models. The authors review the contract details and pricing of such popular credit derivatives as credit default swaps, collateralized debt obligations (CDOs), and basket default swaps. They discuss models for correlated default risk and supply an example of pricing a CDO using Monte Carlo analysis.

The global market for credit derivatives has exploded in recent years; the International Swaps and Derivatives Association released a midyear 2006 report giving $26 trillion as the notional amount of credit derivatives outstanding. In conjunction with the development of credit derivatives markets, research on credit risk has also increased. The objective of this literature review is to provide an introduction to recent quantitative research on the modeling and pricing of credit risk.

WHAT ARE CREDIT DERIVATIVES?

Credit derivatives are contracts in which the payout depends on the default behavior of a company or a portfolio of companies. For example:

• A corporate bond portfolio manager may want to protect his portfolio against the extreme event that more than three companies in his portfolio go bankrupt over the next five years. A credit derivatives contract could insure against such a loss in the same way ...