Credit challenge

Credit derivatives modelling has its foundations in the 1970s, but the rapid growth of the structured credit market over the past 10 years has posed some difficult challenges for quants. Jon Gregory of Barclays Capital looks at the evolution of credit models

Although the credit derivatives market has developed within the past decade, the foundations for pricing were put in place much earlier than that. The Black-Scholes and Merton insights into option pricing led to a model in which the default probability or debt of a company is priced endogenously as a derivative on the underlying firm's value.

This approach, with many extensions (coupons, converts