Credit Risk

Credit risk is the danger that a borrower or counterparty fails to pay. Practitioners decompose it into three ingredients: probability of default, loss given default, and exposure at default; their product is expected loss, whose uncertainty drives capital. Rating systems express default likelihood through letter grades and migration matrices recording how obligors move between states. Two traditions explain default. Merton’s structural model treats equity as a call option on the firm’s assets, with default when assets breach the debt barrier, while reduced-form intensity models treat default as a jump with a stochastic hazard rate. Credit default swaps price this risk continuously, bridging to counterparty risk.