Aurora Borealis
1 July 2000 Financial Analysts Journal Volume 56, Issue 4

Estimating and Pricing Credit Risk: An Overview

  1. Duen-Li Kao

In the past five years, many sophisticated models for pricing credit risk have been developed. The rapid progress in this area is primarily a result of the growth of credit derivatives, securitized asset pools, and other structured products. Factors such as regulatory concerns and the availability of empirical data on default, rating changes, and asset recovery have also sparked interest in credit-risk-pricing models. This article reviews the development of modeling and pricing credit risk during the last three decades. It starts with a discussion of the statistical properties of credit spread behavior over time. It then reviews various quantitative models for assessing a company's creditworthiness and default probabilities. Next, it focuses on the ultimate objective of credit-risk assessment—how credit risk should be priced. First, the basic building blocks of a credit-risk-valuation model—interest rates, default/rating migration, and recovery rates—are discussed. Then, based on these building blocks, the article compares two primary credit-risk-pricing approaches—the structural (firm-value) and the reduced-form models—and reviews several other simple but popular pricing approaches. The article concludes with a brief discussion of credit-risk-pricing applications and possible future research directions.

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