3Modeling Credit Risk: Structural Approach

What Do Credit Risk Models Do?

In the first part of this book, we defined credit risk and discussed how credit derivatives can help transfer credit risk from one party to another. When a party agrees to take on credit risk, she naturally wants to be compensated for the additional risk. Both parties are therefore interested in arriving at a fair price for the credit risk—or more specifically, for the credit derivative used to transfer the risk. We already introduced the idea that traders normally use the credit spread as a price quotation mechanism for credit risk. You might recall that credit spread is the difference in yield between identical Treasury Bonds and nonTreasury Bonds, and that it incorporates ...

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