tailieunhanh - The intersection of market and credit risk

Because Standard & Poor’s and Fitch’s ratings operations are components of larger enterprises that report on a consolidated basis, comparable revenue and asset fifi gures are not possible. But Standard & Poor’s rating operations are roughly the same size as Moody’s, while Fitch is somewhat smaller. Table 1 provides a set of roughly comparable data on each company’s analytical employees and numbers of issues rated. All three companies employ about the same numbers of analysts; however, Moody’s and Standard & Poor’s rate appreciably more corporate and asset-backed securities than does Fitch | ELSEVIER Journal of BẠNỊỌNG _ FINANCE Journal of Banking Finance 24 2000 271-299 locate econbase The intersection of market and credit risk q Robert A. Jarrow a 1j Stuart M. Turnbull b a Johnston Graduate School of Management Cornell University Ithaca New York USA b Canadian Imperial Banck of Commerce Global Analytics Market Risk Management Division BCE Place Level 11 161 Bay Street Toronto Ont. Canada M5J 2S8 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. Default risk and recovery rate uncertainty may not be the sole determinants of the credit spread. We show how to incorporate a convenience yield as one of the determinants of the credit spread. For credit risk management the time horizon is typically one year or longer. This has two important implications since the standard approximations do not apply over a one q The views expressed in this paper are those of the .

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