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

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Chapter 16Credit Valuation

Written in 1984; printed in NetExposure, Issue 1, 1997; reprinted on CD in Derivatives: Theory and Practice of Financial Engineering, P. Wilmott (ed.) (London: John Wiley & Sons, 1998).

The Approach

Credit valuation is a necessary prerequisite to lending. It ensures a desired quality of the asset portfolio, and results in loan pricing that corresponds to the risks assumed. It also provides means to reduce the likelihood of substantive losses through portfolio diversification.

Credit valuation is an objective and quantitative process. It should not depend on the judgment of a particular person or committee. Instead, it should be based on observable quantities, most particularly the market value of the borrower's assets. Credit risk should be measured in terms of probabilities and mathematical expectations, rather than assessed by qualitative ratings. When performed in this manner, we can refer to a credit valuation model.

A credit valuation model requires a theory that describes the causality between the attributes of the borrowing entity (a corporation) and its potential bankruptcy. This does not mean merely an empirical analysis that consists of examining a large number of different variables until a fit is found to the data. Statistical correlations among data do not necessarily signify causal relationships, and therefore provide no assurance of predictive power.

The credit model should be consistent with the modern financial theory, particularly ...

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