10 - The Financial Crisis and the Credit Derivatives Pricing Models

Abstract

The purpose of this chapter is to review the strengths and weaknesses of the main approaches widely used by investment banks, hedge funds and rating agencies to price, grade and hedge credit derivatives and structured credit products. In particular, we show that most of the research devoted to structured credit derivatives pricing models has focused on a better modeling of the correlation structure of credit portfolios. However, this technical issue is not the central cause of the financial crisis since correlations influence the shape of the distribution of losses, but not the expected overall losses that have affected all collateralized debt obligationtranches. A better assessment of unconditional survival probabilities is then needed. We thus advocate for the use of a two-factor model for representing the correlations of a portfolio in order to clearly distinguish between the marginal risk-neutral probabilities of survival (market risk component) and the shape of the distribution of losses (specific risk component). Noticing the difficulty to appraise the respective performance of credit pricing models, we also present a unified approach for testing a model towards its own assumptions. Finally, we highlight the neglected role that could have been played by the enhancement of risk premia during the crisis.