Credit risk is a possible negative change of the value of a credit backed financial instrument due to a default of the borrower or a sudden negative change of the obligor's credit rating. For the latter the crossover to spread risk may be fuzzy or depend on chosen definitions. A fact we like to remind our clients about is that considering the risk linked to a (stochastic) change of the recovery rate in case of default may alter results considerably.
Benoist & Company has strong experience in modeling credit scenarios that take into account stochastic default probabilities. These can be generated either in structural models, like the Merton model, where information about the specific company capital structure is used, or in intensity based models, like the Cox-Ingersoll-Ross model, where the default probability is modeled as a stochastic process. Often the best results are achieved with a hybrid model that uses aspects of both structural and intensity based models.
Over the last decade, one could observe a rapid development of structured credit products including different types of sophisticated credit derivatives and complex instruments which are based on home mortgages, corporate debts, credit card debt requests or car loans. As recent events have shown, an accurate valuation of such structured products is primordial. The rapid growth of these complex credit instruments implies a strong need of advanced credit risk models that exceed the one-factor Gaussian copula model e.g. by taking correlation dynamics into account.