Journal of Credit Risk

Welcome to the December issue of The Journal of Credit Risk. In this issue we have three research papers. 

In cost-of-capital computations, credit risk is only taken into consideration at the level of the debt beta approach. Our first paper, “Costs of capital under credit risk”, by Peter Reichling and Anastasiia Zbandut, shows that applications of the debt beta approach in company valuation suffer from unrealistic assumptions about the market index and the cost of debt. The authors also discuss the valuation errors that result from the debt beta approach’s assumptions regarding the cost of debt. A valuation of Apple Inc as if it were not publicly traded illustrates the procedures of their approach.

“Basel risk weight functions and forward-looking expected credit losses” by Vlachostergios Eleftherios is our second paper. In this paper, the author establishes that the combination of lifetime ECL and the Basel Capital Adequacy Framework, which relies on a one-year horizon, results in capital overestimation. Alongside this finding, and in order to alleviate the problem, they propose two alterations to the risk weight functions that constitute the core of the Basel advanced methodologies.

Finally, we have “Credit valuation adjustment wrong-way risk in a Gaussian copula model”, by Kelin Pan and Chandra Khandrika. This paper presents an analytical expression for CVA with WWR under the assumption of the lognormally distributed trade value. The proposed CVA with WWR model is used to find the CVA alpha that is a function of the market–credit correlation and the counterparty credit quality. The CVA alpha is used to study general WWR and specific WWR. The numerical results show that the entity’s rating downgrade has more of an impact on specific WWR than on general WWR.