Journal of Credit Risk

Michael Ong

Stuart Graduate School of Business, Illinois Institute of Technology

Welcome to the inaugural issue of The Journal of Credit Risk. The Journal is primarily focused on the risk measurement and risk management of credit risk, the valuation and hedging of credit products, and the promotion of greater understanding in the general area of credit risk.

Research in credit risk continues to be a rapidly growing field of endeavor in both financial industry and academia. While both sides have pursued much the same lines of research, a more coherent, formal and integrated venue for all this collective knowledge does not seem to exist. We are publishing The Journal of Credit Risk to fulfill this much-needed role. To this end, your active participation in theoretical research and practical discussions in credit risk are very much appreciated.

The Journal of Credit Risk is your venue for communicating results in the modeling and management of portfolio credit risk, and the pricing and hedging of credit derivatives – particularly structured credit products and securitizations. We encourage the publication of new ideas on measuring, managing and hedging counterparty credit risk, credit risk transfer techniques, liquidity risk and extreme credit events. We also encourage you to submit timely research and discussion topics on regulatory issues covering Basel II, internal ratings systems, credit-scoring techniques and credit risk capital adequacy.

Research Papers

In our inaugural issue, we present three full-length research papers in the main section. In the first paper, Merton's model, credit risk and volatility skews, Hull, Nelken and White revisit the classic 1974 Merton structural form model and propose a method for estimating the model's parameters from the implied volatilities of the options on the company's equity. Using the knowledge that the option on the equity of the company is a compound option on the company's assets, the paper shows that the credit spread in Merton's models can be calculated from the implied volatilities of two options. The results are then compared to credit default swap spread data. The second paper, by Andersen and Sidenius, “Extensions to the Gaussian copula: random recovery and random factor loadings”, provides two extensions of the standard Gaussian copula framework. One extension allows the inclusion of random recovery rates, explicitly allowing for the empirically well-established effect of inverse correlation between recovery rates and default frequencies. The other extension incorporates random systematic factor loadings, effectively allowing default correlations to be higher in bear markets than in bull markets. In both extensions, special cases of the models are shown to be as tractable as the Gaussian copula model and to allow efficient calibration to market credit spreads. The latter extension is shown to be capable of producing correlation skews similar to those observed in the market. The third full-length paper, by Lando and Mortensen, “On the pricing of step-up bonds in the European telecom sector ”, considers the pricing of corporate bonds that allow coupon payments to increase as the credit rating level of the issuer declines. Using the reduced-form rating-based model of Jarrow, Lando and Turnbull (1997), the authors find that, through most of the samples considered, step-up bonds issued by the two largest issuers in the European telecom sector have traded at a discount relative to comparable fixed-coupon bonds from the same issuers. Because their findings cannot be attributed to traditional liquidity factors, they suggest that issuing step-up bonds has increased the cost of capital for the issuers, and therefore raise the question of why firms issue step-up bonds in the first place.

Credit Risk Forum

The Credit Risk Forum constitutes the second main section of The Journal of Credit Risk. The Forum is intended to provide rapid communication on findings and ideas about credit risk that are timely, expository and educational in nature. We strongly encourage readers to submit short discussion articles that are specifically designed to be tutorial and highly educational in nature. The main goal of the submitted articles is to bring a higher level of understanding to both industry and academia on issues and topics that might not normally be readily and easily accessible to either side.

We have three short discussion articles in the Credit Risk Forum section in this issue. The first article, by Finger, “Issues in the pricing of synthetic CDOs”, discusses some of the outstanding implementation and application issues of the standard normal copula framework applied to the pricing of synthetic CDOs and proposes a number of questions for further research. Existing methods for the estimation of return correlation between CDO equity and alternative investments require sophisticated CDO models and proprietary data. CDO market participants often do not have access to the models, the data to run them, or the time to conduct these studies. In the second discussion article, “A correlation estimation method for CDO equity”, Prince explains a simple method called correlation transitivity that permits investors to estimate correlation between CDO equity and alternative investments from correlation between the CDO collateral and the alternative investments. The final discussion article, by Walker, “Risk-neutral correlations in the pricing and hedging of basket credit derivatives”, holds the position that because the market in which the risk-neutral pricing and hedging of basket credit derivatives is incomplete, the risk-neutral approach for correlation gives only upper and lower bounds for the prices of basket credit derivatives, and that these bounds are not sufficiently narrow to be useful in the pricing process. As a result, buyers and sellers of basket credit derivatives have a wide range of arbitrage-free prices to choose from, and it is the market, not risk-neutral pricing, that determines – both in principle and in practice – a definite price.

Problems and Solutions

The Problems and Solutions section is intended to encourage active discussion on how some of the many interesting questions and issues surrounding credit risk can be solved. The section allows readers to post serious, practical questions or to post previously unknown and novel solutions to difficult questions. We have two practical questions for this issue seeking solutions and discussions. The discussions will appear in the next issue.

Book Reviews

Donald Van Deventer reviews the book, Credit Risk Modeling: Theory and Applications, by David Lando, published by Princeton University Press, 2004.

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