"Advanced Credit Risk Analysis: Financial Approaches and Mathematical Models to assess price and manage credit risk"

Abstract

"Advanced Credit Risk Analysis: Financial Approaches and Mathematical Models to assess price and manage credit risk," by Didier Cossin and Hugues Pirotte, is reviewed.

Cossin, Didier and Pirotte, Hugues, "Advanced Credit Risk Analysis: Financial Approaches and Mathematical Models to assess price and manage credit risk", John Wiley & Sons, 2000, pp 357, L55

Credit Risk has always been a major concern for financial institutions and intermediaries. Traditionally this has been addressed by random evaluation or credit risk departments using acturial methods based on historial data. In recent years the massive growth in financial markets combined with the increasing sophistication of financial instruments has turned some of the traditional ways of credit analysis redundant. The rapid growth in the derivative instruments segment has lead forth the formation of sophesticated models/methods for credit risk evaluation independently. Credit Derivatives happen to form the most famous derivative instruments amongst the derivative segment. Also advances in credit pricing and risk management models, together with the development of a sophesticated markets for credit instruments (like credit derivatives), have forced banks, financial institutions and investors alike to re-evaluate their entire approach to credit risk. Researchers and mathematecians around the world have contributed extensively in the last 50 years to develop automated and advanced mechanism for measurment and management of credit risk.

In layman terms credit risk is the risk of default. The concern for the possibility of default of a counterparty on an agreed upon financial contract is centuries old, modern techniques and models have arisen to meet the needs and risks posed by the active structured global financial markets and consumer base. The advancement and fineness in deteremining the credit risk is more important in countries with heavy dependence on debts by masses at large. It is also pertinent for the regions or countries where the default positionings are large. For countries with societal setup having dependence on own funds or savings, the credit functioning does not seap in. With liberalization, globalization and inter-dependences amongst the financial markets/institutions internationally, the credit mechanism plays a vital role in upcoming and developed markets.

Some of the researchers who have extensively worked in the development of instruments and statistical techniques to meausure and manage credit have been Bob Merton (1973, 1974), Black & Cox (1976), Johnson & Sultz (1987), Franks and Torous (1989), J. D. Agarwal (1990s), Cooper & Mello (1991), Jones et. al (1993), Jarrow and Start (1995), Altman & Saunders (1996), Cossin & Pirotte (1998). The authors in the book have briefly touched on some of these before initiating and substantiating on the models in the last decade.

Either we apply some of the lately developed stochastic approaches or the structural approach laid down by Merton, Black and Cox in their models, the function to reduce risk, simplyfy mechanisms, precisely measure risk and then price the instruments, acts as the basic motive in all. The above mentioned work have characterised credit-risk modelling through structural framework, integration of strategic behaviours or optimising schemes, integration of stochastic techniques, discrete or continous-time price models, econometric fitting with/without financial and economic data.

In the proposition for a structured model the defaults, recoveries, and traditional ratings data are anlysed to bring forth the desired features in modeling systems. For functionality aspect in the instruments they are collaterlized, securitized and marked-to-market oriented. Reference to various theories and stochastic models is given in the book for these. Value at Risk (VAR) happens to be the most used concept for evaluation of risk for such instruments. Last decade has seen extensive growth of credit derivative instruments. There is marketability and liquidity component of these instruments, which makes it more acceptable and attractive over the traditional credit instruments. The credit derivative instruments design is based on spreads, events and total return functionality. Credit instruments are extensively used now days in financial structuring via the credit derivative instruments. They are used by corporates, portfolio managers, investors and bankers. This has enabled the growth of the concept and instruments in the markets.

A good attempt to bring forth some of the recent developments and models in credit measurement and management has been made in the book. The readers have been provided with the latest techniques and empirical results on the determinants of credit risk. Though it takes about a decade or two, before a technique really gets accepted in the market to be functional. It is good that the mathematical aspect of the credit risk model has an overview in the initial chapters. The book would prove to be useful for researchers, practioners and master level students who wish to work in this field. Cossin and Pirotte have timely brought forth a comprehensive and balanced synthesis of the concepts, theories and models underpinning modern credit in anagement requirements of the markets and the market makers.