Some Elements of Rating-Based Credit Risk Modeling

by David Lando of the University of Copenhagen

February 24, 1999

Introduction: Default risk must be one of the oldest sources of financial risk that one can think of and yet there has been a surge of interest in the area in the 1990s.  It is difficult to say why this surge did not come earlier, but now that it is there one can look for some reasons:

• Risk management of financial institutions is becoming increasingly complex ...
• Credit derivatives are becoming more popular...

The models we build to handle credit risk are centered around modeling credit events (e.g. defaults or downgrades) and payments on contracts made at such events. When choosing a modeling framework it is important to keep in mind what the purpose of the model is. Different models have advantages in different areas and an attempt to single out a single framework as generally superior is in my opinion misguided. What are the key issues that credit risk models have to address?

• Pricing bank loans and corporate bonds...
• Risk management...
• Pricing credit derivatives...

This paper is republished as Ch.7 in...

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