Abstract

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). Drawing the analogy. Risk 5, 63-70 model. Here default probabilities are correlated due to their dependence on common economic factors.

Citations