Managing Credit Risk in Corporate Bond Portfolios : A Practitioner's ...

CHAPTER 5Modeling Credit RiskCredit risk constitutes the dominant part of the risk in a corporate bondportfolio. As a consequence, the ability to model credit risk accuratelyplays an important role in deciding whether the risk in a corporate bondportfolio can be managed effectively. However, modeling credit risk is amuch more difficult task than modeling market risk. Most of the difficultiesrelate to the differences in the conceptual approaches used for modelingcredit risk and data limitations associated with parameter specification andestimation. Hence, there is invariably a subjective element to the modelingof credit risk and, as such, credit risk modeling is a mixture of art andscience. This subjective element is much more evident when one aggregatescredit risk at the portfolio level, which is discussed in the next chapter. Inthis chapter, I discuss various factors that are important determinants ofcredit risk in a corporate bond and indicate the methods used to estimatethese at the security level. Subsequently, I introduce standard risk measuresthat are used to quantify credit risk.ELEMENTS OF CREDIT RISKCredit risk, in broad terms, refers to the risk of a loss arising from the obligoror issuer not being in a position to service the debt obligations. Also attributedto credit risk is the mark-to-market loss of a bond resulting from achange in the market perception of the issuer’s ability to service the debt in thefuture. In most cases, this change in the market perception will be either precededor succeeded by a change in the credit quality of the issuer. In computingcredit risk at the security level, the following factors play important roles:Probability of default. This is the probability that the issuer will defaulton its contractual obligations to repay its debt. Because probability ofdefault (PD) is a function of the time horizon over which one measuresthe debt-servicing ability, it is standard practice to assume a 1-yearhorizon to quantify this.67