Credit Risk, Credit Quality Drift, and the Business Cycle
Workshop on Research in Financial Mathematics and Engineering
North Carolina State University
May 24, 2001
Abstract
Credit risk is the possibility that a financial asset may lose value because of distress at another institution. A borrower may default on a
loan, an issuer may suspend payments on a bond, a counterparty may be unable to meet its obligations under a derivative contract. The risk
is measured by the size and term of the exposure and the probability of a loss. In the short term, the probability of loss is roughly
proportional to the term, and the principal issue is variability in the exposure. In the long term, the exposure may be controlled in various
ways, and the principal issue is the variability in the probability of loss. A series of downgrades may lead to a substantial increase in that
probability. Our research focuses on the effect of market conditions on the frequency and direction of credit rating changes.