Credit Risk Management and Credit Derivatives

Abstract

Credit risk management is an important issue in banking. In this chapter we give an overview of the models for calculating the default risk exposure of a credit portfolio. The primary goal of these models is to help credit analysts define whether a loan should be issued, which risk premia is appropriate and how much capital should be directed to the loss reserve account. In our presentation we follow Bluhm, Overbeck and Wagner (2010), Li (1998). In the remaining section an important example of a credit risk derivative is shown. A collateralized debt obligation (CDO) is a financial instrument that enables securitization of a large portfolio of assets (i.e. mortgages, auto loans, credit card debt, corporate debt, or credit default swaps (CDS)). This financial product became extremely popular on the brink of the Global Financial Crisis (2007–2009) and therefore captured mainstream media attention, mainly in a negative light. Constructed mostly as a collateral mortgages derivative, CDOs were then next traded on the global financial markets and became (very often highly rated) a part of an institutional investor’s portfolio. After the US housing bubble burst, i.e. that instruments contributed to the spillover effect and thus to the globalization of the crisis. In this chapter we focus on the structure of the CDO and present a modelling and pricing technique.