Credit Risk Frontiers

Credit derivatives are here to stay and will continue to play a role in finance in the future. But what will that role be? What issues and challenges should be addressed? And what lessons can be learned from the credit mess?

Credit Risk Frontiers offers answers to these and other questions by presenting the latest research in this field and addressing important issues exposed by the financial crisis. It covers this subject from a real world perspective, tackling issues such as liquidity, poor data, and credit spreads, as well as the latest innovations in portfolio products and hedging and risk management techniques.

• Provides a coherent presentation of recent advances in the theory and practice of credit derivatives
• Takes into account the new products and risk requirements of a post financial crisis world
• Contains information regarding various aspects of the credit derivative market as well as cutting edge research regarding those aspects

If you want to gain a better understanding of how credit derivatives can help your trading or investing endeavors, then Credit Risk Frontiers is a book you need to read.

Foreword ix
Greg M. Gupton

Introduction 1
Tomasz R. Bielecki, Damiano Brigo, and Frédéric Patras

Part I: Expert Views

Chapter 1 Origins of the Crisis and Suggestions for Further Research 7
Jean-Pierre Lardy

Chapter 2 Quantitative Finance: Friend or Foe? 19
Benjamin Herzog and Julien Turc

Part II: Credit Derivatives: Methods

Chapter 3 An Introduction to Multiname Modeling in Credit Risk 35
Aurélien Alfonsi

Chapter 4 A Simple Dynamic Model for Pricing and Hedging Heterogeneous CDOs 71
Andrei V. Lopatin

Chapter 5 Modeling Heterogeneity of Credit Portfolios: A Top-Down Approach 105
Igor Halperin

Chapter 6 Dynamic Hedging of Synthetic CDO Tranches: Bridging the Gap between Theory and Practice 149
Areski Cousin and Jean-Paul Laurent

Chapter 7 Filtering and Incomplete Information in Credit Risk 185
Rüdiger Frey and Thorsten Schmidt

Chapter 8 Options on Credit Default Swaps and Credit Default Indexes 219
Marek Rutkowski

Part III: Credit Derivatives: Products

Chapter 9 Valuation of Structured Finance Products with Implied Factor Models 283
Jovan Nedeljkovic,Dan Rosen, and David Saunders

Chapter 10 Toward Market-Implied Valuations of Cash-Flow CLO Structures 319
Philippos Papadopoulos

Chapter 11 Analysis of Mortgage-Backed Securities: Before and After the Credit Crisis 345
Harvey J. Stein, Alexander L. Belikoff, Kirill Levin, and Xusheng Tian

Part IV: Counterparty Risk Pricing and Credit Valuation Adjustment

Chapter 12 CVA Computation for Counterparty Risk Assessment in Credit Portfolios 397
Samson Assefa, Tomasz R.Bielecki, StéphaneCrépey, and Monique Jeanblanc

Chapter 13 Structural Counterparty Risk Valuation for Credit Default Swaps 437
ChristophetteBlanchet-Scalliet and Frédéric Patras

Chapter 14 Credit Calibration with Structural Models and Equity Return Swap Valuation under Counterparty Risk 457
Damiano Brigo, Massimo Morini, and Marco Tarenghi

Chapter 15 Counterparty Valuation Adjustments 485
Harvey J. Stein and Kin Pong Lee

Chapter 16 Counterparty Risk Management and Valuation 507
Michael Pykhtin

Part V: Equity to Credit

Chapter 17 Pricing and Hedging with Equity-Credit Models 539
Benjamin Herzog and Julien Turc

Chapter 18 Unified Credit-Equity Modeling 553
Vadim Linetsky and Rafael Mendoza-Arriaga

Part VI: Miscellanea: Liquidity, Ratings, Risk Contributions, and Simulation

Chapter 19 Liquidity Modeling for Credit Default Swaps: An Overview 587
Damiano Brigo, Mirela Predescu, and Agostino Capponi

Chapter 20 Stressing Rating Criteria Allowing for Default Clustering: The CPDO Case 619
Roberto Torresetti and Andrea Pallavicini

Chapter 21 Interacting Path Systems for Credit Risk 649
Pierre Del Moral and Frédéric Patras

Chapter 22 Credit Risk Contributions 675
Dan Rosen and David Saunders

Conclusion 721
Tomasz R. Bielecki, Damiano Brigo, and Frédéric Patras

Further Reading 725

About the Contributors 727

Index 729

TOMASZ R. BIELECKI is a Professor of Applied Mathematics at the Illinois Institute of Technology. He is the author of numerous research papers in the areas of stochastic analysis, stochastic control, manufacturing systems, operations research, and mathematical finance. Bielecki is a coauthor of the monographs Credit Risk: Modeling, Valuation and Hedging and Credit Risk Modeling. He has been a recipient of various research grants and awards and consults for various financial companies.

DAMIANO BRIGO was recently appointed as Gilbart Professor of Financial Mathematics at King’s College, London, heading the research of the mathematical finance group. He has published more than fifty works in top journals on mathematical finance, systems theory, probability, and statistics; a book for Springer-Verlag that has become a field reference in stochastic interest rate modeling; and a book for Wiley on credit models and the crisis. Brigo obtained a PhD in stochastic filtering with differential geometry in 1996 from the Free University of Amsterdam.

FRÉDÉRIC PATRAS is Director of Research at the Centre National de la Recherche Scientifique (Université de Nice, France) and head of quantitative analysis at Zeliade Systems, a software and service provider for financial institutions. He studied at the École Normale Supérieure (Paris) and obtained a PhD in mathematics at the Université Paris 7–Denis Diderot. He has authored more than thirty research papers in combinatorics, mathematical physics, probability, statistics, and mathematical finance.

THE SIZE AND COMPLEXITY of credit markets in general, and credit derivatives in particular, have posed a serious challenge for both market practitioners and quantitative modelers. While the demands of trading and risk management in this rapidly growing market have spurred the development of quantitative methodologies for modeling, valuation, and management of credit risk—with a focus on credit derivatives—the recent financial crisis has proven that the challenges we face in this field have not been fully, and sometimes, properly addressed.

Nobody understands this better than Tomasz Bielecki, Damiano Brigo, and Frédéric Patras. And now, with Credit Risk Frontiers, they’ve created an innovative volume—comprised of contributed articles from some of today’s most respected academics and practitioners in this area—that deals with several urgent topics, such as the subprime crisis, the pricing and hedging of credit risk, collateralized loan obligations (CLO), ratings, and liquidity.

Divided into six comprehensive parts, this reliable guide provides a coherent presentation of the recent advancements in the theory and practice of credit risk analysis and management, with an emphasis on issues that are relevant to the current state, and future, of credit markets. Page by page, Credit Risk Frontiers:

• Offers expert insights on the role of quantitative modeling during the recent credit crisis and the modeling lessons learned from this period
• Discusses general methods in multiname credit derivatives—namely derivatives products that depend on more than one credit entity at the same time
• Explores asset-backed securities (ABS), in which the analysis of cash flows represents specific difficulties that aren’t present in the familiar synthetic collateralized debt obligation (CDO) framework
• Details the hybrid modeling of credit and equity, and examines the application domain of equity-to-credit modeling that runs from the joint pricing of credit and equity to relative value analysis
• Addresses issues associated with the valuation of credit valuation adjustments (CVA) and counterparty risk in the current environment
• And much more

The information found here presents a renewed picture of the field, taking into account the lessons of the past to push forward with new models, ideas, and methods. Designed for those who are serious about understanding new ways of modeling and managing credit risk and derivatives, Credit Risk Frontiers will help you excel at this difficult endeavor.