12. Credit Risk Management
This chapter introduces credit risk, which can be defined as the risk of loss due to a counterparty's failure to honor an obligation. Default risk, which is a key element of credit risk, introduces an important source of nonnormality into the portfolio distribution. We first introduce the Merton model to help us understand default of a single counterparty. Default risk has an important effect on how corporate debt is priced, but default risk will also impact the equity price. We build on the single-firm Merton model to develop a factor model of credit portfolio risk. The portfolio model provides a framework for computing credit Value-at-Risk. Finally, the chapter introduces credit default swaps, which give a market-based ...
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