Managing Credit Risk with Credit Derivatives

Gilroy, Bernard Michael and Broll, Udo (2005): Managing Credit Risk with Credit Derivatives.

Abstract

Given a commercial banking firm facing credit risk we develop a dynamic hedging model where the bank management can use credit derivatives. In a continuous-time framework optimal hedging strategies, deposit and loan decisions and consumption are studied. It is shown that the optimal hedge ratio consists of two elements: a speculative term which is controlled by the risk premium and the bank's risk aversion; and a pure hedge term which depends on the preferences of bank owners. Primarily the purpose of hedging is to stabilize the consumption path through a reduction in the variability of the dynamics of the wealth accumulation. Furthermore, we demonstrate that the asset/liability management is optimal if marginal cost equal marginal revenue for loans and deposits at each instant.

• Item Type: MPRA Paper
• Language: English
• Keywords: Banking firm; asset/liability management; credit risk; credit derivatives; dynamic hedging.
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates

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