Financial Risk Management: Models, History, and Institutions

CHAPTER 6

Credit and Counterparty Risk

To understand credit risk and how to measure it, we need both a set of analytical tools and an understanding of such financial institutions as banks and rating agencies. In this chapter

• We define credit risk and its elements, such as the likelihood that a company goes bankrupt, or the amount the investor loses if it happens.
• A great deal of effort goes into assessing the credit risk posed by borrowers. This is, in fact, one of the oldest activities of banks. We will look at different ways this is done, including both time-sanctioned, relatively non-quantitative techniques and more recently developed modeling approaches.
• As with market risk, we sometimes want to summarize credit risk in one number, such as credit Value at Risk, so we will also look at quantitative approaches to measuring credit risk.

This is the first, covering basic concepts, in a sequence of chapters on credit risk. One way credit risk is expressed is through the spread, or the difference between credit-risky and risk-free interest rates. Since the market generally demands to be compensated for credit risk, credit-risky securities are priced differently from securities that promise the same cash flows without credit risk. They are discounted by a credit risk premium that varies with the perceived credit risk and market participants’ desire to bear or avoid credit risk. When measured in terms of the interest rate paid on a debt security, this premium is part of the credit ...