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On Some Inconsistencies In Modeling Credit Portfolio Products

Author

Listed:
  • FRANK J. FABOZZI

    (School of Management, Yale University, 135 Prospect Street, New Haven CT 06520-8200, USA)

  • RADU TUNARU

    (Credit Investments, BMO Capital Markets, UK)

Abstract

The survival probability term structure has become the main concept in modeling credit risk for pricing, risk management, and investment decisions. The Kth-to-default contract is not only a relatively liquid credit risk instrument but also a vehicle that credit rating agencies employ to determine the rating of more esoteric credit risky positions. In this paper, we point out some subtleties in credit risk modeling of default baskets and also identify some potential bias in the pricing formula of the Kth-to-default contract. The numerical examples suggest that this bias increases with the correlation. The results in this paper emphasize the important role of conditioning the information regarding arrival of default.

Suggested Citation

  • Frank J. Fabozzi & Radu Tunaru, 2007. "On Some Inconsistencies In Modeling Credit Portfolio Products," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(08), pages 1305-1321.
    • Handle: RePEc:wsi:ijtafx:v:10:y:2007:i:08:n:s0219024907004664
    DOI: 10.1142/S0219024907004664
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    Cited by:

    1. Thomas Lagner & Dodozu Knyphausen‐Aufseß, 2012. "Rating Agencies as Gatekeepers to the Capital Market: Practical Implications of 40 Years of Research," Financial Markets, Institutions & Instruments, John Wiley & Sons, vol. 21(3), pages 157-202, August.
    2. Radu Tunaru, 2015. "Model Risk in Financial Markets:From Financial Engineering to Risk Management," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 9524, August.

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