Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

11.1 Introduction

Credit risk is ubiquitous in modern finance: “Credit risk is the risk that the value of a portfolio changes due to unexpected changes in the credit quality of issuers or trading partners. This subsumes both losses due to defaults and losses caused by changes in credit quality” (McNeil, Frey, and Embrechts 2005, 327).

In many ways, the analysis of credit risk is no different from risk arising in any other part of a firm's business. The focus is on the distribution of gains and losses (P&L) and how information about gains and losses can be used to manage the business of the firm.¹

Although the underlying idea is simple, particular characteristics of credit risk mean that the techniques used to estimate and analyze credit risk are often different and more complex than for market risk. The distribution of P&L can be very difficult to estimate for a variety of reasons (see McNeil, Frey, and Embrechts, 2005, 329):

Most credit risks are not traded and market prices are not available, so the distribution of gains and losses must be constructed from first principles, requiring complex models.

Public information on the quality and prospects for credit risks are often scarce. This lack of data makes statistical analysis and calibration of models problematic. (Additionally, ...