Chapter 15

An Introduction to Credit Risk

Using Market Signals in Loan Pricing and Performance Measurement

In the first 14 chapters of this book, the fundamental emphasis has been to lay the foundation for an integrated treatment of credit risk, market risk, liquidity risk, and interest rate risk. We now introduce the analysis of credit risk, building on the foundation, which we established with our prior focus on the term structure of interest rates in a multifactor Heath, Jarrow, and Morton (HJM) framework.

MARKET PRICES FOR CREDIT RISK

Our primary focus in this chapter is to introduce the use of market prices in credit risk analysis. In subsequent chapters, we discuss the state-of-the-art models that are used with this market data to construct an integrated approach to market risk, interest rate risk, liquidity risk, and credit risk. As you will see, in those chapters, as well as this one, we will emphasize best practice. That said, it is important to add a word of warning about “past practice” and some of its dangers.

For a large insurance company or pension fund, the use of market signals in credit risk analysis is accepted without question because so much of the fixed income portfolio consists of bonds issued by large, highly rated issuers. This is definitely not the case in the banking industry, especially with the demise of the purely wholesale-oriented commercial banks such as First Chicago, Continental Illinois, the old JP Morgan, and the Industrial Bank of Japan. Even ...

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