Credit derivatives as an efficient way of transitioning to optimal portfolios

By Alla Gil

The key challenge in optimising credit-risky portfolios is measuring risk/return trade-off consistently with the pricing of overlaying instruments used for transition to an optimal portfolio. This chapter describes an original hybrid methodology that measures portfolio credit risk consistently with the pricing and hedging techniques. We construct an efficient frontier for the given portfolio, explicitly taking into consideration possible default events. Then we identify the optimal portfolio on the frontier that is the most appropriate for the nature of existing portfolio. Finally, we demonstrate how to overlay various credit derivatives structures in order to transform the current portfolio into the optimal one.

INTRODUCTION

As discussed in the last chapter, the last decade has seen a number of methodologies for evaluating credit risk on a portfolio basis has greatly increased and now includes such well-known packages as KMV (see Kealhoffer, 1995), CreditPortfolioView (see Wilson, 1997), CreditRisk+ (see Credit Suisse Financial Products, 1997) and CreditMetrics (see CreditMetrics). This increase is the direct result of the development of credit derivatives markets. While credit

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