Extracting Risk Measures from Credit Derivatives and Bonds

Jorge A Chan-Lau

The previous chapter reviewed different methods for evaluating the solvency or probability of default of a single institution. These methods rely on fundamental information about the institution, gathered mainly from financial statement data and publicly available ratings, and complemented by economic data reflecting the stage of the business cycle.

In many circumstances, however, fundamental information may not be sufficient. Financial statements are released with substantial lags, leading to outdated risk assessments. Mapping ratings data to probabilities of default requires historical default data that may fail to reflect the current business and economic environment. A dramatic example of this situation was the inability of ratings to reflect the risks of subprime mortgages and the securitised instruments they supported owing to the structural shift in underwriting standards in the run up to the subprime crisis in 2008.

Securities prices are a valid alternative to fundamental information for calculating the default risk of the issuer, as they reflect market participants’ projections of the cashflows accrued to the securities. While markets may not necessarily assess correctly