Credit Risk and the Structuring of Cash Flows
Credit risk is dispersion in financial outcomes associated with the failure or potential failure of a company or counterparty to fulfill its obligations. Credit risk, unlike market risk, contains substantial idiosyncratic risk. Market risk arises from unexpected changes in economy-wide risk factors, such as interest rates, equity prices, and currency rates. Credit risk is primarily and typically related to the nonperformance of a single firm or counterparty. Further, in contrast to market risk, which may lead to 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, while the downside performance could lead to the loss of the entire investment.
This chapter begins with an analysis of credit risk and the models that exist to measure and manage credit risk. The final part of the chapter is an introduction to structuring cash flows using multiple securities. The center of this more advanced level of structuring is the collateralized debt obligation.
23.1 AN OVERVIEW OF CREDIT RISK
The return from credit risk can be a substantial part of a bond's total return. There are three important types of credit risk: default risk, downgrade risk, and credit spread risk.
Default risk is the risk that ...