| Topic : Credit risk management in banks |
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Posted in Community :
Credit Risk Management
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Activity:
20 views;
last activity : 07 06 2010 20:18:09 +0000
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The structural approach
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Reduced form approach
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Ideas in:
"Pricing credit risk"
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One approach is the structural approach to credit default looks at a credit risky bond or swap as a credit risk less bond or swap, minus an option to exchange the bond or swap for the debtor's portfolio in bankruptcy. The approach is on sound theoretical footing, practical for a firm with a trivial capital structure, but questionable for a firm with a complex capital structure.
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The reduced form approach multiplies the states of the world, beyond the usual ones with interest rate derivatives, to include states where the debtor defaults. The risk neutral probability of default and the recovery rate in default are important variables here. This approach is theoretically correct, but has a few practical problems. The recovery rates, after default, are hard to come by. Deducing the risk neutral probability of default depends on knowing the recovery rates, having a rich set of debt instruments for the debtor, and assuming that default and the level of risk less rates is independent. |
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