Credit risk tools: an overview

Esposito, Francesco Paolo (2010): Credit risk tools: an overview.

Abstract

This document presents several Credit Risk tools which have been developed for the Credit Derivatives Risk Management. The models used in this context are suitable for the pricing, sensitivity/scenario analysis and the derivation of risk measures for plain vanilla credit default swaps (CDS), standardized and bespoke collateralized debt obligations (CDO) and, in general, for any credit risk exposed A/L portfolio.\\ In this brief work we compute the market implied probability of default (PD) from market spreads and the theoretical CDS spreads from historical default frequencies. The loss given default (LGD) probability distribution has been constructed for a large pool portfolio of credit obligations exploiting a single-factor gaussian copula with a direct convolution algorithm computed at several default correlation parameters. Theoretical CDO tranche prices have been calculated. We finally design stochastic cash-flow stream model simulations to test fair pricing, compute credit value at risk (CV@R) and to evaluate the one year total future potential exposure (FPE) and derive the value at risk (V@R) for a CDO equity tranche exposure.

• Item Type: MPRA Paper
• Language: English
• Keywords: interest rate swap, spot rate term structure, credit default swap, probability of default, copula function, direct convolution, loss given default, collateralized debt obligation, exposure at default, stochastic cash-flow stream model, value at risk, credit value at risk, future potential exposure, Monte Carlo simulation.
• Subjects: C - Mathematical and Quantitative Methods > C0 - General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; G - Financial Economics > G0 - General

References

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Zhen Wei, Credit Risk: Modeling and Application, Stanford University

Iftikhar U. Hyder, The Barclays Capital Guide to Cash Flow Collateralized Debt Obligations, Barclays Capital 2008.