Chapter 24 Credit Risk

Most of the derivatives considered so far in this book have been concerned with market risk. In this chapter we consider another important risk for financial institutions: credit risk. Most financial institutions devote considerable resources to the measurement and management of credit risk. Regulators have for many years required banks to keep capital to reflect the credit risks they are bearing.

Credit risk arises from the possibility that borrowers and counterparties in derivatives transactions may default. This chapter discusses a number of different approaches to estimating the probability that a company will default and explains the key difference between risk-neutral and real-world probabilities of default. ...

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