Abstract
Lending money is one of the core businesses of banks. The income from this business line comes in the form of interest income and we will now discuss why different borrowers will be charged different interest costs in the same lending market.
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- 1.
Payment obligations which can lead to a default can also result from other contracts, such as bonds, swaps, options, forwards.
- 2.
Note that apart from the borrower’s credit risk, the interest charged will also depend on the costs arising due to regulatory requirements (e.g. capital requirements), the costs at which banks can finance themselves, and the level of competition in the specific lending market.
- 3.
Source: Moody’s (2012), see www.moodys.com.
- 4.
Source: Standard & Poor’s Global Fixed Income Research (2012): 2011 Annual Global Corporate Default Study And Rating Transitions, www.standardandpoors.com/ratings/articles/.
- 5.
This model greatly simplifies the balance sheet of the company, since other liabilities (such as reserves or employee pension provisions) are not considered here.
- 6.
Spread-widening risk caused large losses during and after the 2007/08 credit crisis, when credit spreads significantly increased (or: widened) in fear of future defaults, and bond and loan holders had to take losses when selling credit products in the market.
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The traded price of the equity will however in some cases provide satisfactory information on the market view of the value of the company assets.
- 9.
A structural model was first applied to the pricing of stock derivatives by Robert Geske in 1979 and leads to the problem of pricing a compound option (i.e. an option on an option).
- 10.
Other traded credit instruments, as discussed in Section 15.5, can also be applied to calibrate credit risk models.
- 11.
The parameter λ(t) can be interpreted as the current spread rate over an infinitesimal time interval, similar to the current short rate r(t) in interest rate models.
- 12.
Credit derivatives are traded OTC, so that volume estimates are based on figures reported by CDS dealers (mostly banks). Also note that the market volume is normally reported in terms of notional amounts – paid premiums will only account for a fraction of this. The Bank of International Settlement (BIS) collects and publishes OTC derivative volume estimates for the G10 countries and Switzerland in its quarterly reviews, see www.bis.org.
- 13.
The most widely used CDS index in Europe is iTraxx Europe and describes the credit performance of a pool of the 125 most liquid European CDS names. See www.markit.com.
- 14.
Modeling dependence is an active field of research (see references at the end of the chapter).
References
T. R. Bielecki and M. Rutkowski. Credit Risk: Modelling, Valuation and Hedging. Springer Finance. Springer-Verlag, Berlin, 2002.
F. Black and J. Cox. Valuing corporate securities: some effects of bond indenture provisions. Journal of Finance, 31(2):351–367, 1976.
C. Bluhm, L. Overbeck, and C. Wagner. An Introduction to Credit Risk Modeling. Chapman & Hall/CRC, Boca Raton, FL, 2003.
M. Hanke. Credit Risk, Capital Structure, and the Pricing of Equity Options. Springer-Verlag, Wien, 2003.
R. Merton. The pricing of corporate debt: the risk structure of interest rates. Journal of Finance, 29(2):449–470, 1974.
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Albrecher, H., Binder, A., Lautscham, V., Mayer, P. (2013). Introduction to Credit Risk Models. In: Introduction to Quantitative Methods for Financial Markets. Compact Textbooks in Mathematics. Birkhäuser, Basel. https://doi.org/10.1007/978-3-0348-0519-3_15
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