Chapter 13 Credit Risk What is credit risk? Credit risk arises from the possibility that borrowers and counterparties in derivatives transactions may default. 2 2 2 Contents Approaches to estimating the probability that pany will default The difference between risk-neutral and real-world probabilities of default Credit risk of derivative Default correlation, Gaussian copula models 3 3 3 Approaches to estimating default probabilities Historical default probabilities of panies From bonds prices From equity prices From derivatives prices Historical cumulative average default rates (%) Define V(t) as cumulative probability of pany surviving to time t. Taking limits, we get Define Q(t) as the probability of default by time t. Where is the average default intensity between 0 and t Recovery rate The recovery rate for a bond is usually defined as the price of the bond immediately after default as a percent of its face value Recovery rates are significantly negatively correlated with default rates Recovery rates (Moody’s:1982 to 2006, Table , page 491)