Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 24. Credit Risk

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. There are three types of credit risk: credit default risk, credit spread risk, and downgrade risk. Counterparty risk in a trade transaction is an example of credit risk. Today, there are several vehicles for transferring credit risk from the banking sector to the nonbanking sector of the economy.

Keywords: credit risk, credit default risk, credit spread risk, downgrade risk, credit risk transfer (CRT) vehicle, credit rating, rating agency, investment grade, noninvestment grade, distressed debt, high-yield bonds, junk bonds, collateral, capacity, character, covenants, reorganization, liquidation, voluntary bankruptcy, involuntary bankruptcy, default rate, recovery rate, counterparty risk, upgrade, downgrade, event risk, jump risk, rating migration table, credit derivatives

While investors commonly refer to credit risk as if it is one dimensional, there are actually three forms of this risk. Credit default risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. To gauge credit default risk, investors rely on analysis performed by nationally recognized statistical rating organizations that perform credit analysis of issues and issuers and express their ...