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Managing Credit Risk with Credit Derivatives

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  • Gilroy, Bernard Michael
  • Broll, Udo

Abstract

Given a commercial banking firm facing credit risk we develop a dynamic hedging model where the bank management can use credit derivatives. In a continuous-time framework optimal hedging strategies, deposit and loan decisions and consumption are studied. It is shown that the optimal hedge ratio consists of two elements: a speculative term which is controlled by the risk premium and the bank's risk aversion; and a pure hedge term which depends on the preferences of bank owners. Primarily the purpose of hedging is to stabilize the consumption path through a reduction in the variability of the dynamics of the wealth accumulation. Furthermore, we demonstrate that the asset/liability management is optimal if marginal cost equal marginal revenue for loans and deposits at each instant.

Suggested Citation

  • Gilroy, Bernard Michael & Broll, Udo, 2005. "Managing Credit Risk with Credit Derivatives," MPRA Paper 17678, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:17678
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    References listed on IDEAS

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    1. Briys, Eric & Crouhy, Michel & Schlesinger, Harris, 1990. "Optimal Hedging under Intertemporally Dependent Preferences," Journal of Finance, American Finance Association, vol. 45(4), pages 1315-1324, September.
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    Cited by:

    1. Lakshmi, P., 2016. "Feasibility study of credit risk rating systems in banks," Asian Journal of Empirical Research, Asian Economic and Social Society, vol. 6(12), pages 294-306, December.

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    More about this item

    Keywords

    Banking firm; asset/liability management; credit risk; credit derivatives; dynamic hedging.;
    All these keywords.

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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