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

11.9 Dynamic Reduced Form Models

We now turn to pricing credit-risky securities. The analysis of credit risk in this chapter has focused on credit risk management—measuring and using the P&L distribution for a portfolio or business activity over some (usually long) period. In this section, we change gears to focus on market pricing of credit-risky securities. We will see that these models apply to credit risk when such risk can be traded. As such, it moves away from the tools and techniques we have discussed in this chapter and moves more toward the arena of market risk that we discussed in earlier chapters.

The goal of this section is to introduce the idea, not to provide a comprehensive overview. The pricing of credit-risky securities is a large and growing area. Duffie and Singleton (2003) wrote a textbook devoted to the topic. McNeil, Frey, and Embrechts (2005) devote chapter 9 of their book to the topic. This section will do no more than provide the briefest introduction.

There have been two important changes in the markets for credit-risky securities over recent years. First, an increasing variety and volume of credit risks are being actively traded. Thirty years ago few credit-risky securities beyond corporate bonds were traded, and many bonds were only thinly traded. Loans, receivables, leases, all were held to maturity by institutions and virtually never traded. Now there is a wealth of derivative securities (credit default swaps prime among them), collatoralized structures, ...