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Special to Kalamalama by Gunter Meissner, Associate Professor of Finance

What is credit risk?

Credit risk is the risk that a debtor cannot pay back his debt. For example, an Enron employee has invested $100,000 in Enron bonds for his retirement. As we all know, Enron went into bankruptcy and most employees lost their retirement investments. Was there any way the employees could have protected themselves? The answer is yes; they could have use credit derivatives.

What are credit derivatives?

These are new financial instruments that protect against credit risk. In our example, the Enron employees could have called JP Morgan and asked for a credit default swap. This is just a fancy word for an insurance against default. The Enron employee would pay a fee to JP Morgan. If Enron defaults, they would get back their retirement investment of $100,000 from JP Morgan.

Careers for students

The market for credit derivatives is about eight years old and has experienced phenomenal growth, doubling in 2006 and achieving a $17 trillion volume. As a consequence of the enormous growth, investment and commercial banks are struggling to keep up with the credit derivatives deal flow. Banks are looking for front office staff as traders and brokers, middle office risk-managers, and back office staff to settle the trades.

That’s where HPU comes in. Students in Risk Management (Fin 3650, Fin 6801) and Advanced Derivatives class (Fin 3610, Fin 6610) are preparing for careers in credit derivatives. Several of them already work in risk management in New York, London, Hong Kong, Singapore, and Frankfurt.

Research

Since the market for credit derivatives is still in its infancy, there are more questions than answers with respect to the valuation and risk management of credit derivatives. For example, what would have determined the value of credit default swap, i.e., insurance against default, on the part of Enron?

Naturally, the default probability of Enron.

Should we also include the default probability of the insurance seller, JP Morgan? The answer is yes. The lower the credit quality of JP Morgan, the less we want to pay them since they too might default.
What about the default correlation between Enron and JP Morgan? This is actually quite important. If they both default, the investor is still ruined, since he loses his $100,000 investment and his insurance. If the default correlation between Enron and JP Morgan is 1, the default swap is worthless, since if Enron defaults, so will JP Morgan.

What about the default probability of the investor? This also has to be included, if the default swap premium is paid periodically. If the investor has a low credit quality, he might not be able to pay his premium and JP Morgan will suffer a loss. What about the default correlation between the investor and Enron? This goes on and on and on.

Editor’s note: Meissner has identified 21 input factors and correlations that determine the fair market price of credit default swaps. He and former HPU student Janne Kettunen, who is currently pursuing his Ph.D. in London, developed a model that correlates the various parameters and stochastic default processes. The latest version is at www.dersoft.com/dskkmlmmcopula.xls.
 

 

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