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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 15Introduction to Part IV

Contemporary credit analysis comprises the following three areas:

  1. Credit valuation of individual borrowers, as expressed in probability of default, and in the risk-neutral probability of default needed for debt pricing;
  2. Portfolio risk measurement, taking into account the correlation of defaults, resulting in determining the probability distribution of portfolio losses, and of changes in the portfolio value; and
  3. Structuring and pricing of credit derivatives, such as credit default swaps or collateralized debt obligations.

The theory of derivative asset pricing (options pricing) of Black, Scholes, and Merton opened up means of quantitative assessment of creditworthiness and pricing of debt securities. By being able to derive values of corporate liabilities from the market price of equity and its volatility, it became possible to measure credit risk in terms of probabilities of default rather than ordinal ratings.

The paper “Philosophy of Credit Valuation”(Chapter 16), written in 1984, provides an extensive argument for such methodology, as opposed to the previously established approach. Traditional approaches to credit valuation, such as agency ratings, involve a detailed examination of company's operations, projection of cash flows, measures of leverage and coverage, an assessment of the firm's future earning power, and so on. An assessment of the company's future, however, has already been made by all market participants and is reflected in ...

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