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

11.4 Taxonomy of Credit Risk Models

Two Areas of Modeling Credit Risk

There are two areas of application and two ways in which “credit risk modeling” is used. The first is credit risk management—measuring and using the P&L distribution for a portfolio or business activity over some (usually long) period. Such credit risk modeling is the primary focus of this chapter, and models are usually static in the sense that they focus on the distribution for a fixed time, and are concerned less with the time process of default and loss or the details of when default occurs.

The second application of credit risk modeling is the pricing of credit-risky securities, whether new developments such as credit default swaps or traditional securities such as corporate bonds. This is a large area, addressing how to price instruments such as bonds, loans, CDS, or other credit derivatives. Models for pricing such instruments are usually dynamic in the sense of modeling the time that default or other loss occurs—that is, modeling the stochastic process of losses. Such models are not the primary focus of this chapter.

Recognizing the two types of modeling and the distinction between them is useful for two reasons. First, the techniques used in pricing “credit-risky” securities are often related to those used in credit risk measurement. Second, understanding the distinction between pricing “credit-risky” securities and credit risk measurement clarifies the types of models and approaches used.

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