Stochastic Methods in Credit Risk

Modelling, Valuation
and Hedging
Introduction to Credit Risk and Credit
Derivatives

Tomasz R. Bielecki
Northeastern Illinois University
[email protected]

In collaboration with Marek Rutkowski

Part 1: Portfolio Credit Risk

 Measuring credit risk.

 Portfolio analysis.
 CVaR models.
 CreditMetrics.
 CreditGrades.
 Counterparty credit risk.
 Reference credit risk.

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Part 2: Credit Derivatives

 Counterparty credit risk.

 Reference credit risk.
 Classification of credit derivatives.
 Total return swaps.
 Credit default swaps.
 Spread linked swaps.
 Credit options.

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Part 3: Mathematical Modelling

 Merton’s model of corporate debt.

 Black and Cox approach.
 Intensity-based approach to credit risk.
 Hybrid models.
 Implied probabilities of default.
 Markov models of credit ratings.
 Market risk and term structure models.

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Credit Risk: Modelling, Valuation
and Hedging

Part 1: Portfolio Credit Risk

The central point is the quantitative estimate of
the amount of economic capital needed to
support a bank´s risk-taking activities
Measuring Credit Risk

 Credit risk models should capture:

 Systematic vs Idiosyncratic Risk Sources
 Credit spread risk,
 Downgrade risk (credit rating),
 Default risk (default probability),
 Recovery rate risk (recovery rate),
 Exposure at default (loss given default),
 Portfolio diversification (correlation risk),
 Historical Probabilities vs Risk-Neutral Probabilities.

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Portfolio Analysis I

 What is really important:

 Concentration risk, Basle Committee 25% rule; Herfindahl-Hirshman
Index

 Diversification effect,
 Rating structure,
 CVaR, Credit Value-at-Risk
 Risk-adjusted performance measures,
 Capital optimisation,
 Sensitivity and stress test analysis.

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Portfolio Analysis II

Important questions to risk managers:

 How should we define and measure credit risk
of a portfolio of loans or bonds?
 What are the measures of capital profitability
the bank should apply?
 What is the risk-return profile of the bank’s
credit portfolio?
 What is the capital amount required for the
assumed rating of the bank’s credit portfolio?

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Portfolio Analysis III

 Which credit exposures represent the highest

risk-adjusted profitability?
 What are the main factors affecting the bank’s
credit portfolio risk-adjusted profitability?
 What are the main sources of the bank’s
credit risk concentration and diversification?
 How can the bank improve it’s portfolio
profitability?

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CVaR Models I

 Types of Credit Risk Models:

 Risk aggregation:
- Top-down, Aggregate risk in consumer, credit card, etc., portfolios;
default rates for entire portfolios
- Bottom-up, Individual asset level; default rates for individual obligors.
 Systemic factors recognition:
- Conditional,
- Unconditional.
 Default measurement:
- Default mode, Two modes: default or no-default
- Mark-to-market (model), Credit migrations accounted for.

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CVaR Models II

 Currently proposed industry sponsored

CVaR models:
 CreditMetrics (RiskMetrics),
 CreditGrades (RiskMetrics),
 Credit Monitor/EDF (KMV/Moody’s),
 CreditRisk+ (Credit Suisse FB),
 CreditPortfolioView (McKinsey).

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CVaR Models III

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CreditMetrics I

 A tool for assessing portfolio risk due to

changes in debt value caused by changes in
obligor credit quality.
 Changes in value caused not only by possible
default events, but also by upgrades and
downgrades in credit quality are included.
 The value-at-risk (VaR) - the volatility of value,
not just the expected losses, is assessed.

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CreditMetrics II

 Risk is assessed within the full context of a

portfolio. The correlation of credit quality moves
across obligors is addressed. This allows to
directly calculate the diversification benefits.
 Value changes are relatively small with minor
up(down)grades, but could be substantial if
there is a default (rare event).
 This is far from the more normally distributed
market risks that VaR models typically address.

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CreditMetrics III

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CreditMetrics IV

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CreditGrades I

 Is meant to provide a simple framework linking the

credit risk and equity markets (a first-passage-time
model).
 Tracks the risk-neutral default probabilities.
 Based on the ideas of the structural approach,
due to Merton (1973), Black and Cox (1976).
 Main deficiency are artificially low short-term credit
spreads. CreditGrades corrects this by taking
random default barrier and recovery rate.
 This is essentially a pricing model

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CreditGrades II

 Asset value V follows a lognormal proces with

a constant volatility (under real-world probability).
 Default occurs at the first crossing of the default
barrier by V.
 Default barrier is the product of the expected
global recovery of the firm’s liabilities and the
current debt per share of the firm.
 The CreditGrade is the model-implied 5-year
credit spread.

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CreditGrades III

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CreditGrades: Case Study

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CreditGrades: Spin Summary

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CreditGrades: No Spin Critique

 CG appears to mix statistical and risk neutral

probabilities.
 CG assumes no-drift condition for asset value
process, which appears to be unjustified.
 Transparent formulae for probabilities of default
resulting in CG framework and, apparently,
relying on market observables only, appear to be
founded on questionable (in general) relationship
between volatility of equity and volatility of the
asset value process.

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Credit Monitor I

 Credit Monitor provides M-KMV’s EDF credit

measures on corporate and financial firms
globally, updated on a monthly basis with up
to five years of historical EDF information.
 EDF (expected default frequency) is a
forward looking measure of actual
probability of default. EDF is firm specific.
 Credit Monitor model follows the structural
approach to calculate EDF’s. [The credit risk
is driven by the firm’s value process.]
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Credit Monitor II

 Credit Monitor deals with firms whose

equities are publicly traded. The market
information contained in the firm’s stock
price and the balance sheet is mapped to
the firm’s EDF.
 Credit Monitor used in M-KVM’s Portfolio
Manager

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CreditRisk+ I
 An approach focused only on default event; it
ignores migration and market risk.
 For a large number of obligors, the number of
defaults during a given period has a Poisson
distribution. The loss distribution of a bond/loan
portfolio is derived.
 Belongs to the class of intensity-based (or
reduced-form) models. Default risk is not linked
to the capital structure of the firm.

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CreditRisk+ II

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CreditPortfolioView
 A multifactor model focused on the simulation
of the joint distribution of default and migration
probabilities for various rating groups.
 Default/migration probabilities are linked to the
state of the economy through macroeconomic
factors (an econometric model).
 Conditional probabilities of default are modelled
as a logit function of the index:

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Credit Risk: Modelling, Valuation
and Hedging

Part 2: Credit Derivatives

The central points are providing protection
against credit risk and diversification of
credit risk exposure
Counterparty Credit Risk

 Derivatives trading generates exposure to

the credit risk of the counterparty involved in
a given contract (typical examples: bonds,
vulnerable options, defaultable swaps).
 Counterparty credit risk is a function of:
 Creditworthiness of the counterparty,
 Size of profits accrued yet unrealised,
 Ability to use legally binding netting
agreements.

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Reference Credit Risk

 Credit derivatives are privately held negotiable

bilateral contracts that allow users to manage their
exposure to credit risk, so-called reference credit
risk.
 Credit derivatives are financial assets like forward
contracts, swaps and options for which the price is
driven by the credit risk of economic agents (private
investors or governments).

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Why Credit Derivatives?

 Credit derivatives connect the different fixed-income

markets by being the “clearing-house” for credit risk
transfer.
 Insurance against credit events to reduce borrowing
costs.
 Diversification of exposure by means of synthetic
loans.
 Assume positions in markets that might otherwise be
inaccessible.
 Accounting and tax advantages.

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Default Protection

 Default protection:
Suppose a bank concerned that one of its
customers may not be able to repay a loan.
The bank can protect itself against loss by
transferring the credit risk to another party, while
keeping the loan on its books.
 Useful links: www.defaultrisk.com

www.margrabe.com

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Special Features

 Pay-out typically based on extremal event (for

instance, the default event).
 Limited liquidity (currently).
 Insurance components may require actuarial
analysis (under statistical probability).
 Operational risk management important - can’t
buy perfect insurance, and tail events are
extremal (Bankers Trust)

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A Simplified Taxonomy

 Credit derivatives are usually rather involved.

They can be divided into three basic classes:
 Swaps:
- Total rate of return swap, default swap, and
spread-linked swap.
 Notes:
- Default note, spread-linked note, and levered
notes.
 Options:
- Price, spread, and default options.

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Spectrum

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Vanilla Credit Derivatives

 Total return (or asset) swap - TRS,

 Credit-linked note - CLN,
 Credit default swap (or option) - CDS,
 Securitized pool (of corporates) - CDO,
 Option on a corporate bond,
 Credit spread swap (or option),
 Insured cash-flow stream (swap guarantee).

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Total Return Swap I

Asset Total Return

Party A Party B

Floating Payments

Underlying assets may be bonds, loans, or other credit

instruments. Permits the separation of asset ownership
and economic exposure: balance sheet rental or
out-sourcing, for example.

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Total Return Swap II

 Total Rate of Return Swap is a derivative contract

that simulates the purchase of an instrument (note,
bond, share, etc.) with 100% financing, typically
floating rate.
 The contract may be marked to market at each
reset date, with the total return receiver receiving
(paying) any increase in value of the underlying
instrument, and the total return payer receiving
(paying) any decrease in the value of the underlying
instrument.

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Credit Default Swap I

Default Premium

Party A Party B

Recovery (after default)

Recovery is paid only if there is a default, so this is a

“pure” credit risk product. That is, price and spread
risk is stripped away. B’s exposure is like that of an
off-balance sheet loan.

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Credit Default Swap II
 Credit default swap is a contract between a buyer
and a seller of protection, in which:
 (a) the buyer of protection pays the seller a fixed,
regular fee,
 (b) the seller of protection provides the buyer with a
contingent exchange that occurs either at the
maturity of the underlying instrument or at the
swap's date of early termination. The trigger event
for the contingent payoff is a defined credit event (a
default on the underlying instrument or other related
event).

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Credit Default Swap III

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Credit Default Swap IV

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Credit Default Swap V

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Spread-Linked Swap

Periodic payments

Party A Party B

Payments based on spread

B’s payments are based on the credit spread of

a reference security. B may only make a final
payment at maturity based on the credit spread.
A pays LIBOR plus a fixed spread, say.

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Default Notes
Default notes: For example, an issuer (credit card
company, say) agrees to pay back $100 at maturity and
8% coupons semiannually, but if some default event
occurs the coupons drop to 4%.

The investor will pay less than he would for a similar note
without credit-linkage in compensation for the option he
has sold to the issuer.

Spread-linked notes: Like above, except that here the

coupon paid by the investor depends on the credit
spread for some reference security.
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Levered Notes

 For example, corporate bonds might be pooled, and

the cash-flows repackaged in the form of a note that
pays a high (leveraged) coupon in return for accepting
with this the risk that the payments will stop (or be
significantly reduced) if there are one or more defaults
in the pool.

 The cash-flows might also be packaged in the form of

lower-yielding money market instruments, thus earning
profits for the issuer (at the cost of accepting some of
the credit risk). In this case, it is the issuer who assumes
the levered position.
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Credit Options

 Security with the payoff contingent on the

following credit events:
 the price of a reference security drops below
a strike price (determined by a strike spread),
 the credit spread for a reference security
tightens or widens, or
 there is a default event of the reference
entity.
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Exotic Variations
 Basket credit derivatives (correlation-sensitive
products).
 Event-contingent option (if a certain project is
completed on time, say).
 Real options (sell real decision risk instead of market
factor risk).
 Fixed-income products linked to earthquakes or other
catastrophes.
 Notes linked to real earnings and inflation (less
volatility in real rates).

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Types of Risks

 Credit risk (obvious) and the price risk (since

this affects profitability, and therefore credit
quality).
 Operational risk (contingency planing for
worst-case scenario, for example).
 Liquidity risk (can be mitigated by doing
deals back-to-back, and including early
termination provisions).
 Legal risk (Orange County).

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Benefits from Credit Derivatives

 Better serve customer needs.

 Diversification of exposures.
 Efficient use of balance sheet.
 Profiting from market views.
 Traders receive information on order
flow, customer interest, etc.

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Credit Risk: Modelling, Valuation
and Hedging

Part 3: Mathematical Modelling

The central point is providing formal quantitative tools to
properly serve the purposes listed in Parts 1 and 2
Merton’s Model of Corporate Debt

Let us denote:
 V - total value of the firm’s assets,
 L - face value of the firm’s debt,
 T - maturity of the debt,
 - (random) time of default.
Default occurs at time T if the total value of the
firm’s assets at time T is lower than the face
value L of the firm’s debt.

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Dynamics of Firm’s Assets
The process representing the total value of the firm’s
assets is governed by the stochastic (random) equation:

where is the standard Brownian motion

(one-dimensional Wiener process).
The interest rate and the dividend yield
are constant.
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Merton’s Default Time

The time of default is given by

The recovery payoff at time equals

and thus the corporate bond satisfies

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Merton’s Valuation Formula

The price at time of a -maturity corporate

bond equals:

where is the time to maturity

and

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Black and Cox Model

 Basic assumptions of Merton’s model are preserved.

Value of firm’s assets is lognormally distributed.
 The random instant of default is specified as the first
moment the value of the firm crosses some barrier:
premature default.
 The latter assumption is assumed to represent the so-
called safety covenants.
 Closed-form solution for the value of corporate debt is
available (but it is rather involved).

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Structural Approach

 The total value of the firm’s assets is not

easily observed. The total value of shares
can be taken as a proxy.
 The internal structure of the reference firm
is an essential ingredient of the model.
 On the other hand, both the cross-default
provision and the debt’s seniority structure
are relatively easy to cover.

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Intensity-Based Approach

 Value of the firm is not explicitly modelled.

 The intensity of the random time of default
plays the role of a model’s input.
 Valuation result for corporate bonds and
credit derivatives are relatively simple, even
in the case of basket credit derivatives.
 In practice, the intensity of default can be
inferred from observed prices of bonds
(the calibrated or implied default intensity).

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Default Time

 Structural approach: is a predictable stopping time

with respect to the filtration generated by the value
process. Default is announced by a sequence of
stopping times.
 Intensity-based approach: is a totally inaccessible
stopping time with respect to the reference filtration
(including the observations of the default time. Default
comes as a surprise.

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Credit Ratings
 Some more recent methods take into account
not only the default event, but also the current
and futures rating of each firm.
 In most cases, the process that models the
up/downgrades is a Markov process.
 Instead of a default intensity, the whole matrix
of intensities of migrations is specified.
 Official ratings are given by specialized rating
agencies; they do not necessarily reflect (risk-
neutral) probabilities of credit migrations.

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Intensities of Migrations
The matrix of intensities of credit migrations has the following form

where K is the number of credit ratings and

the K-th class represents default event.
State K is an absorbing state.
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References
• M. Ammann: Credit Risk Valuation: Methods,
Models, and Applications. Springer 2001.
• A. Arvanitis and J. Gregory: Credit Risk:
The Complete Guide. Risk Books 2001.
• T. R. Bielecki and M. Rutkowski: Credit Risk:
Modelling, Valuation and Hedging. Springer 2002.
• D. Cossin and H. Pirotte: Advanced Credit Risk
Analysis. J. Wiley & Sons 2000.
• B. Schmid: Pricing Credit Linked Financial
Instruments. Springer 2002.
• D. Duffie and K. J. Singleton: Credit Risk, Princeton
University Press 2003.
CreditGrades II

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