12 - Credit Risk Management

Abstract

This chapter provides some important stylized facts on corporate default and recovery rates and develops a theoretical framework for understanding default based on Merton's seminal model. Merton's model studies one firm in isolation but it can be generalized to a portfolio of firms using Vasicek's factor model structure. The factor model can be used to compute VaR in credit portfolios. This chapter briefly discusses credit default swaps, which are the financial instruments most closely linked with default risk. Credit risk can be defined as the risk of loss due to a counterpart's failure to honor an obligation in part or in full. Credit risk takes several forms; for banks credit risk arises fundamentally through its lending activities. Nonbank corporations provide short-term credit to their debtors face credit risk as well. Investors who hold a portfolio of corporate bonds or distressed equities need to get a handle on the default probability of the assets in their portfolio. Default risk, which is a key element of credit risk, introduces an important source of nonnormality into the portfolio in this case. Credit risk can also arise in the form of counterparty default in a derivatives transaction.