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This chapter is from the book

How to Read This Book

Investors face all sorts of risk and not just credit risk. Grouping risks into different “baskets” helps investors choose which type(s) of risk to accept and which to leave for other investors. They might try to minimize company-specific risk through diversification, or use long-short strategies to cancel out market risk as they speculate on converging prices for individual securities. Interest rate risk is a common concern for anyone else looking to finance a large project. Investors who consume in one currency but invest in another are exposed to currency risk.

This book, however, addresses none of these risks. Instead, it focuses on another important risk that is often borne by investors, namely the risk that a company or individual cannot meet its obligations or liabilities on schedule: credit risk.

Part I, “What Is Credit Risk?,” covers the basics of credit risk. It defines what credit is, what facing credit risk might entail, and also gives a short overview of some common credit derivative tools that transfer credit risk from those investors who do not want to bear it to those investors who are willing to accept it. The two chapters also discuss concepts such as default probabilities, recovery rates, and credit spreads.

After the introduction, Part II, “Credit Risk Modeling,” then goes into detail on how credit risk models can be used to describe and predict credit risk events. It covers three different approaches to modeling credit risk: the structural, empirical, and reduced-form approaches. Chapter 3 focuses on structural models. It features the Merton model as an example of the approach, and also discusses the Black and Cox, and Longstaff and Schwartz models. Chapter 4 looks at empirical models, especially the Z-model, and reduced-form models, such as the Jarrow-Turnbull model.

Part III, “Typical Credit Derivatives,” concludes the book by discussing in detail two specific credit derivative instruments used to transfer credit risk. Chapter 5 looks at credit default swaps (CDSs), Chapter 6 at collateralized debt obligations (CDOs), and Chapter 7 covers today’s applications for financial instruments with embedded credit risk.

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