11.3 Stylized Credit Risk Model

Introduction

My treatment of credit risk and credit modeling diverges from the approach usually taken in risk management texts. The current section lays out a stylized model to provide a framework for understanding how credit risk models are used. Section 11.4 provides a taxonomy of models (largely following McNeil, Frey, and Embrechts 2005, ch. 8 and ch. 9). Section 11.5 then briefly discusses specific models (Merton's [1974], KMV, CreditMetrics, CreditRisk+) and puts them into context, using the stylized model of the current section.

Most treatments, in contrast, start with a discussion of what is credit risk, industry practice for analyzing and categorizing credit risk, and detailed description of one or more specific credit models, such as Merton's (1974) option-theoretic model of default or industry-developed models such as KMV or CreditMetrics. I will refer to other texts for background on actual credit risk practice and models. Crouhy, Mark, and Galai (2000, ch. 7 through 12) is a particularly good review of banking industry practice and models. (Crouhy, Mark, and Galai 2006, ch. 9 through 12 provides a somewhat less detailed overview.) McNeil, Frey, and Embrechts (2005, ch. 9 and particularly ch. 8) provides a good treatment of the technical foundations for credit models. Marrison (2002, ch. 16 to 23) also has an extensive discussion of industry practice and modeling, with chapter 17 providing a particularly nice overview of the variety of ...

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