Risk Finance and Asset Pricing: Value, Measurements, and Markets

CHAPTER 9

Credit Scoring and the Price of Credit Risk

OVERVIEW

Credit risk has emerged as one of the most important problems of finance. “Credit is a disposition of one man to trust another” (Walter Bagehot, nineteenth century). It is a trust that one bestows on a party to meet commitments negotiated a priori. Credit risk exposure arises when there is a lack of trust and credit contract parties may face adverse consequences. For example, lending money requires the belief and a trust that the borrower will both pay its debt and pay on time. When parties exchange (swap) assets and default occurs, a credit risk event occurs if one or both parties do not meet the terms set by the contract. Credit risk is thus the consequence of a change in terms, time of payment, or whether payments are not made or are made partly. Pricing and managing credit risk are thus important. This chapter focuses on individual credit risk, credit scoring, and credit granting, while the next chapter addresses credit risk and derivatives. These topics are likely to be of increased interest due to the attention that financial institutions are devoting to control their risk and more carefully select credit applicants.

CREDIT AND MONEY

Finance is about money—a means of exchange that provides value to the parties engaged in such an exchange. Money assumes many forms. For example, in antiquity and in the Middle Ages, money was a minted metal—bronze, silver, and gold. The holding and hoarding of such metals provided ...