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The Intersection of Market and Credit Risk
Company: Journal of Banking and Finance
Company Url: Click here to open
Year Of Publication: 2000
Month Of Publication: January
Pages: 271-299
Download Count: 1324
View Count: 6808
Comment Num: 0
Language: EN
Source: article
Who Can Read: Free
Date: 8-29-2002
Publisher: Administrator
Summary
Economic theory tells us that market and credit risks are intrinsically related to each other and not separable. We describe the two main approaches to pricing credit risky instruments: the structural approach and the reduced form approach. It is argued that the standard approaches to credit risk management -- CreditMetrics, CreditRisk+ and KMV -- are of limited value when applied to portfolios of interest rate sensitive instruments and in measuring market and credit risk. Empirically returns on high yield bonds have a higher correlation with equity index returns and a lower correlation with Treasury bond index returns than do low yield bonds. Also, macro economic variables appear to influence the aggregate rate of business failures. The CreditMetrics, CreditRisk+ and KMV methodologies cannot reproduce these empirical observations given their constant interest rate assumption. However, we can incorporate these empirical observations into the reduced form of Jarrow and Turnbull (1995b)[REF]. Drawing the analogy. Risk 5, 63--70 model. Here default probabilities are correlated due to their dependence on common economic factors. Default risk and recovery rate uncertainty may not be the sole determinants of the credit spread. We show how to incorporate a convenience yield as one of the determinants of the credit spread. For credit risk management, the time horizon is typically one year or longer. This has two important implications, since the standard approximations do not apply o
Author(s)
Jarrow, Robert Sign in to follow this author
Turnbull, Stuart Sign in to follow this author
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