Alternative Investments: CAIA Level I, 3rd Edition

CHAPTER 26 Credit Risk and Credit Derivatives

Credit risk is dispersion in financial outcomes associated with the failure or potential failure of a counterparty to fulfill its financial obligations. In contrast to equity-related risk, which tends to have somewhat symmetrical payoff distributions, credit risk generally leads to payoff distributions that are substantially skewed to the left. In other words, the upside performance of a traditional position exposed to credit risk is limited to the recovery of the original investment plus the promised yield, whereas the downside performance could lead to the loss of the entire investment.

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The material in this chapter assumes familiarity with credit ratings, credit spreads, and credit rating migration.

26.1 An Overview of Credit Risk

Default risk is the risk that the issuer of a bond or the debtor on a loan will not repay the interest and principal payments of the outstanding debt in full. A debtor is deemed to be in default when it fails to make a scheduled payment on its outstanding obligations. Default risk can be complete, in that no amount of the bond or loan will be repaid, or it can be partial, in that some portion of the original debt will be recovered.

Credit risk is influenced by both macroeconomic events and company-specific events. For instance, credit risk typically increases during ...