Measuring the Risk of Default: A Modern Approach

The US is a nation of debtors. The size of the debt market is quite large. The primary risk of all this debt is credit risk, or the risk of default. Investors measure default risk in many different ways, and there have been important recent innovations in this regard. The state of the art in assessi...

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Bibliographic Details
Published inThe RMA Journal Vol. 90; no. 10; p. 70
Main Authors Hilscher, Jens, Jarrow, Robert A, Deventer, Donald R van
Format Trade Publication Article
LanguageEnglish
Published Philadelphia Robert Morris Associates 01.07.2008
Subjects
Accuracy
Benchmarks
Corporate debt
Credit risk
Default
Equity
Financial institutions
Probability
Put & call options
Regression analysis
Risk management
Small business
Standard deviation
United States > US
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Summary:The US is a nation of debtors. The size of the debt market is quite large. The primary risk of all this debt is credit risk, or the risk of default. Investors measure default risk in many different ways, and there have been important recent innovations in this regard. The state of the art in assessing corporate credit risk is based on one of three approaches: 1. the Merton distance-to-default measure, 2, the reduced-form approach, and 3. credit ratings. This article will compare and contrast these three approaches, showing that the reduced-form approach is preferred because of its generality, flexibility, and superior forecasting ability. Risk managers are seeking an enterprise-wide ability to manage risk as the default probabilities across all borrowers rise and fall with the macroeconomic factors driving the business cycle. Only a reduced-form approach to credit risk modeling allows a risk manager to achieve this objective with the essential speed and accuracy required.
ISSN:1531-0558