Credit Securitisations and Derivatives: Challenges for the Global Markets

13

Pricing and Calibration in Market Models

Frank Gehmlich1, Zorana Grbac2, * and Thorsten Schmidt3

1Chemnitz University of Technology

2University of Evry Val d’Essonne

3Chemnitz University of Technology

13.1 INTRODUCTION

A credit portfolio consists of a number of different credit names (obligors). Modeling of credit portfolio risk is a challenging task which relies on the adequate quantification of the two main sources of risk. The first one is market risk, which is the risk stemming from the changes in interest rates and changes in the credit quality of the single credit names in the portfolio. The second is correlation risk (also known as default correlation) among these credit names. A good model for credit portfolio risk should incorporate both sources of risk.

The main purpose of credit portfolio risk modeling is valuation and hedging of various contingent claims on a portfolio. In general, securities whose value and payments depend on a portfolio of underlying assets are termed asset-backed securities. For an overview and detailed descriptions of different types of asset-backed securities we refer to Part I of this book. Credit portfolio risk tranching is discussed in Part III.

In the literature two main approaches can be found for credit portfolio models: the bottom-up approach, where the default intensities of each credit name in the portfolio are modeled, and the top-down approach, where the modeling object is the aggregate loss process of the portfolio. Both approaches ...