Credit Risk Modeling

David Lando

Abstract The chapter gives a broad outline of the central themes of credit
risk modeling starting with the modeling of default probabilities, ratings and
recovery. We present the two main frameworks for pricing credit risky instru-
ments and credit derivatives. The key credit derivative - the Credit Default
Swap - is introduced. The premium on this contract provides a meausure of
the credit spread of the reference issuer. We then provide some key empirical
works looking at credit spreads thorugh CDS contracts and bonds and finish
with a description of the role of correlation in credit risk modeling.

1 Introduction

Credit risk modeling is a rapidly growing area of financial economics and

financial engineering. Banks and other financial institutions are applying in-
creasingly sophisticated methods for assessing the risk of their loan portfo-
lios and their counterparty exposure on derivatives contracts. The market for
credit derivatives is growing at an extreme pace with the credit default swap
and the CDO markets as the primary sources of growth. These new mar-
kets and better data availability on the traditional corporate bond market
have provided new laboratories for financial economists to test asset pricing
theories, to look at capital structure decisions, and to understand financial
innovation.
Classical credit risk analysis is concerned with deciding whether a loan
should be granted and, after a loan has been granted, trying to assess the risk
of default. Modern credit risk analysis still addresses these issues but there
is more focus on pricing of loans and corporate bonds in secondary markets

David Lando
Copenhagen Business School, Department of Finance, Solbjerg Plads 3, DK-2000 Fred-
eriksberg, Denmark, e-mail: dl.fi@cbs.dk

T.G. Anderson et al., Handbook of Financial Time Series, 787

DOI: 10.1007/978-3-540-71297-8_35, © Springer-Verlag Berlin Heidelberg 2009
788 D. Lando

and on the pricing and hedging of derivative contracts whose pay-offs depend
on the performance of a single bond or loan or on a portfolio of bonds or
loans. This survey will focus on the modeling of corporate bond prices and
credit spreads and on some implications for modeling credit derivatives. These
are areas of credit risk modeling where rich data sets and well-developed
pricing models allow for extensive econometric analysis. There are interesting
econometric challenges in more traditional credit scoring but we only have
time to touch briefly upon this topic. Other topics will not be covered at all,
including the role of credit risk in the macro-economy (credit crunches, the
role of credit in the propagation of business cycles), implications for optimal
capital structure decisions of firms and capital adequacy requirements for
banks.

2 Modeling the Probability of Default and Recovery

The decision theoretic problem of whether to grant a loan or not has been
attacked for a long time using financial ratios but the systematic attempts
of looking at which predictors perform well was started in Altman (1968)
and Beaver (1966) who mainly rely on discriminant analysis, an attempt of
classifying firms into defaulting or non-defaulting groups based on company
characteristics. The outcome of the analysis is a discriminant function which
maps the relevant predictors into a single score and classifies the company
as a defaulter or a non-defaulter based on whether the score is above or
below a certain threshold. The derivation of the discriminant function and
the threshold can be based on a likelihood approach or on a decision theoretic
approach, in which a cost is assigned to misclassification. For the precise
arguments, see for example Anderson (1984). This method of analysis was
in part chosen for computational convenience and it is not easily adapted
to a dynamic framework with time-varying covariates. The method is also
not well-suited for handling the effects of covariates that are common to all
firms such as business cycle indicators. The use of computers have greatly
facilitated the use of logistic regression methods, see for example Shumway
(2001) and survival analytic methods based on hazard regressions, see for
example Duffie et al. (2004) which both deal easily with dynamic features of
the model, common covariates and which offer default probability predictions
useful for risk management.
As an alternative to developing full models for default probabilities of in-
dividual firms, investors in corporate bonds often use the ratings which are
assigned to bond issuers by the major rating agencies. The ratings are based
on analysis of the company’s key ratios and on meetings with the issuers. Rat-
ings play important roles in a regulatory context when assigning risk-weights
to assets, in defining loan covenants and investment guidelines and as a sig-
nalling device to less informed investors. Given these important roles, there
Credit Risk Modeling 789

is a substantial literature on the statistical behavior of ratings focusing on

various forms of non-Markov behavior, business cycle dependence, the ability
of ratings to forecast default and their information content measured through
price reactions in markets around rating changes. A number of references to
this literature can be found in Lando (2005)
The recovery rates on defaulted bonds play an important role in pricing
both bonds and derivatives but systematic research into what determines
recovery rates is still relatively new. For a comprehensive recent study, see
Acharya et al. (2007) which also contains a number of references.

3 Two Modeling Frameworks

Models for default probabilities and recovery are important inputs to pricing
models for loans, bonds and derivatives but we need more structure in the
models than what we get from a statistical model to actually perform the
pricing. A statistical model typically gives us estimates of default probabil-
ities as a function of certain explanatory variables, but the dynamics of the
explanatory variables are not modeled. A pricing model needs to include the
full dynamics of the explanatory variables.
There are broadly speaking two approaches to pricing corporate bonds
and these approaches are outlined in this section. One approach - sometimes
referred to as the structural approach - views equity and bonds (and other
claims to the firm’s assets) as derivative contracts on the market value of a
firm’s assets. It then uses option pricing theory to price these claims. This
approach is systematically carried out in Merton (1974) in a Black-Scholes
setting. To briefly summarize the approach, assume that the market value of
a firm’s assets follows a geometric Brownian motion

dVt = μVt dt + σVt dWt

where W is a standard Browninan motion and that the firm has issued a
zero coupon bond promising to pay the principal D at the maturity date
T. Assume that the actual pay-off of the bond at maturity is min(VT , D).
This means that debt holders receive their payment in full if the firm has
sufficient assets to pay, but if assets are insufficient the bondholders take
over the remaining assets. In the setting of a Black-Scholes market with a
constant interest rate r the price of this bond is give at time zero as

B0 = D exp(−rT ) − P BS (V0 , D, σ, r, T )

where P BS denotes the value of a European put option in the Black-Scholes

setting. We can translate this bond price into a (promised) yield
790 D. Lando

1 B0
y(T ) = − log
T D
and by varying T in this expression we obtain what is known as the risk struc-
ture of interest rates. We obtain the credit spread by subtracting the riskless
rate r from the promised yield. The most important observation from this
relationship is that yield spreads increase when leverage, i.e. the ratio of D to
V, increases and when asset volatility increases. Note that credit spreads are
increasing in volatility and do not distinguish between whether the volatility
is systematic or non-systematic. The expected return of the bond is sensi-
tive to whether volatility risk is systematic or not. So one should carefully
distinguish between credit spreads and expected returns on corporate bonds.
There are many modifications and extensions of the fundamental setup
outlined above. Bonds may pay continuous or lumpy coupons, there may be
a lower boundary which when reached by the asset value of the firm causes the
firm to default. This lower boundary could represent bond safety covenants or
liquidity problems of the firm and it could represent future capital structure
decisions of the firm trying to maintain a stationary leverage ratio. Dynamics
of key inputs may be changed as well, allowing for example for stochastic
interest rates or jumps in firm asset value. For a survey, see Lando (2005). The
structural models differ in how literally the option approach is taken. Several
of the models impose default boundaries exogenously and obtain prices on
coupon bonds by summing the prices of zero-coupon bonds obtained from
the risk structure of interest rates - an approach which does not make sense
in the Merton model, see Lando (2005) for a simple explanation.
A special branch of the literature endogenizes the default boundary, see
Leland (1994) and Leland and Toft (1996), or takes into account the ability
of owners to act strategically by exploiting that the costs of bankruptcy are
borne by the debt holders, see for example Anderson and Sundaresan (1996).
Applying contingent claims analysis to corporate bonds differs from con-
tingent claims pricing in many important respects. Most notably, the market
value of the underlying assets is not observable. In applications the asset value
must therefore be estimated and for companies with liquid stocks trading a
popular approach has been to estimate the underlying asset value and the
drift and volatility of the asset value by looking at equity prices as transfor-
mations (by the Black-Scholes call option formula) of the asset value. It is
therefore possible using the transformation theorem from statistics to write
down the likelihood function for the observed equity prices and to estimate
the volatility and the drift along with the value of the underlying assets. For
more on this, see Duan (1994).
The option-based approach is essential for looking at relative prices of
different liabilities in a firm’s capital structure, for discussing optimal capital
structure in a dynamic setting and for defining market-based predictors of
default.
The second approach to spread modeling - sometimes referred to as the
reduced-form approach or the intensity-based approach - takes as given a
Credit Risk Modeling 791

stochastic intensity of default which plays the same role for default risk as
the short rate plays in government term structure modeling. The advantage of
this approach is precisely that it integrates the modeling of corporate bonds
with modeling of the default-free term structure of interest rates, and this
makes it particularly suitable for econometric specification of the evolution
of credit spreads and for pricing credit derivatives.
Early intensity models are in Jarrow and Turnbull (1995) and Madan and
Unal (1998) and the full integration of stochastic intensities in term structure
models is found in Lando (1994, 1998) and Duffie and Singleton (1999). The
integration using a Cox process setup proceeds as follows. A non-negative
stochastic process λ describes the instantaneous probability of default under
a risk-neutral measure Q, i.e.

Q(τ ∈ (t, t + Δt]|Ft ) = 1{τ >t} λt Δt

where Ft contains information at time t including whether the default time

τ is smaller than t. Assume that the intensity process λ and a process for
the riskless short rate r are adapted to a filtration (Gt ) where Gt ⊂ Ft , and
assume that the default time τ of a firm is modeled as
 t +
τ = inf t : λ(s)ds ≥ E1 .
0

where E1 is an exponentially distributed random variable with mean 1 which

is independent of the filtration (Gt ). In accordance with the formal defini-
t
tion of an intensity, it can be shown that 1{τ ≤t} − 0 λ(s)1{τ ≥s} ds is an Ft -
martingale. The key link to term structure modeling can be seen most easily
from the price v(0, T ) of a zero coupon bond maturing at T with zero recov-
ery in default (in contrast with B0 defined earlier) and issued by a company
with default intensity λ under the risk-neutral measure Q :
8   9
T
v(0, T ) = E Q exp − rs ds 1{τ >T }
0
8   9
T
=E Q
exp − (rs + λs )ds .
0

A key advantage of the intensity models is that the functional form for the
price of the defaultable bond is the same as that of a default-free zero-coupon
bond in term structure modeling, and therefore the machinery of affine pro-
cesses can be applied. This is true also when the formula is extended to allow
for recovery by bond holders in the event of default, see for example Lando
(2005).
In the reduced-form setting prices of coupon bonds are typically computed
by summing the prices of zero-coupon bonds - an approach which clearly
should be applied with caution. It is suitable for valuing credit default swaps
792 D. Lando

(see below) in which the contract has no influence on the capital structure
of the firm or for assessing the default risk of small additional exposures of a
firm for example in the context of counterparty risk in derivatives contracts.
Pricing large new corporate bond issues will require an intensity which takes
into account the effects on leverage of the new issue.
The division between the two approaches should not be taken too literally.
A structural model with incomplete information under certain assumptions
can be recast as an intensity model as shown in Duffie and Lando (2001),
and nothing precludes an intensity model from letting the default intensity
depend on the asset value of the firm and other firm specific variables.
Estimation of intensity models is performed in Duffee (1999) and Driessen
(2005) using a Kalman filter approach. Duffie and Singleton (1997) focus
on swap rates in an intensity-based setting. The default intensity process is
treated as a latent process similar to the short-rate process in classical term
structure modeling. This means that estimation proceeds in close analogue
with estimation of term structure models for default-free bonds. There is
one important difference, however, in how risk premia are specified for de-
fault intensities and for the riskless rate. To understand the difference in a
single factor setting, think of a diffusion-driven short rate depending on a
single Brownian motion, as for example in the Cox-Ingersoll-Ross setting.
The change of measure between the physical measure and the risk-neutral
measure corresponds to a change of drift of the Brownian motion. A similar
change of measure can be made for the intensity controlling the default time
of a defaultable bond issuer. However, it is also possible to have an intensity
process which is changed by a strictly positive, multiplicative factor when
going from the physical to the risk-neutral measure. This gives rise to an
important distinction between compensation for variation in default risk and
compensation for jump-event risk. For more on this distinction, see Jarrow
et al. (2005) and for a paper estimating the two risk premia components
separately, see Driessen (2005).

4 Credit Default Swap Spreads

The first empirical work on estimating intensity models for credit spreads
employed corporate bond data, but this is rapidly changing with the explosive
growth of the credit default swap (CDS) market. The CDS contracts have
become the benchmark for measuring credit spreads, at least for the largest
corporate issuers. A CDS is a contract between two parties: one who buys and
one who sells protection against default of a particular bond issuer which we
call the reference issuer. The protection buyer pays a periodic premium, the
CDS premium, until whichever comes first, the default event of the reference
issuer or the maturity date of the contract. In the event of default of the
reference issuer before the maturity of the CDS contract, the protection seller
Credit Risk Modeling 793

compensates the protection buyer for the loss on a corporate bond issued
by the reference firm. The compensation is made either by paying a cash
amount equivalent to the difference between the face value and the post
default market value of the defaulted bond or by paying the face value while
taking physical delivery of the defaulted bond. In practice, there is a delivery
option allowing the protection buyer to deliver one of several defaulted bonds
with pre-specified characteristics in terms of seniority and maturity. The CDS
premium is set such that the initial value of the contract is zero.
Forming a portfolio of a credit risky bond and a CDS contract with the
same maturity protecting against default on that bond, one has a position
close to a riskless bond and this gives an intuitive argument for why the credit
default swap premium ought to be close to a par bond spread on a corporate
bond. For a more rigorous argument, see Duffie (1999).
It is illustrative to use the intensity setting to compute the fair premium
on a CDS, i.e. the premium which gives the contract value 0 at initiation. In
practice, this relationship is primarily used to infer the default intensity from
observed CDS prices and then price other derivatives from that intensity,
or to analyze risk premia of default by comparing market implied default
intensities with actual default intensities.
To clearly illustrate the principle, consider a stylized CDS with maturity T
years, where premium payments are made annually. As above, let the default
intensity of the reference issuer be denoted λ under a risk-neutral measure Q.
Then the present value of the CDS premium payments made by the protection
buyer before the issuer defaults (or maturity) is simply


T  t 
T
pb = c
π E Q exp(− rs ds)1{τ >t} = c v(0, t)
t=1 0 t=1

where v(0, t) is the value of a zero recovery bond issued by the reference firm
which we used as the basic example above. If we write the probability of
surviving past t under the risk neutral measure as
 t
 
S(0, t) = E Q exp(− λs ds)
0

and we assume (as is commonly done when pricing CDS contracts) that the
riskless rate and the default intensity are independent, then we can express
the value of the protection payment made before default occurs as


T

π pb
=c p(0, t)S(0, t)
t=1

where p(0, t) is the value of a zero-coupon riskless bond maturing at date t.

This formula ignores the fact that if a default occurs between two payment
dates, the protection buyer pays a premium determined by the fraction of a
794 D. Lando

period that elapsed from the last premium payment to the default time. If
we assume that default happens in the middle between two coupon dates,
then the value of this extra payment should be added to get the value of the
protection payment:
 
c
T
1
pb +
π pb = π p(0, t − ) S(0, t) − S(0, t − 1) .
2 t=1 2

The value of the protection seller’s obligation is more complicated (but cer-
tainly manageable) if we insist on taking into account the exact timing of
default. To simplify, however, we again assume that if a default occurs be-
tween two default dates, it occurs in the middle, and the settlement payment
is made at that date. Furthermore, we assume a recovery per unit of principal
equal to δ, so that the protection seller has to pay 1 − δ to the protection
buyer per unit of notional. Still assuming independence of the riskless rate
and the default intensity, we obtain


T  
1
π ps
= (1 − δ) p(0, t − ) S(0, t) − S(0, t − 1) .
t=1
2

The fair CDS premium c can now be found by equating π pb and π ps . In

practice payments are often made quarterly in rates equal to one fourth of
the quoted annual CDS premium.
There are several advantages of using CDS contracts for default studies:
First of all, they trade in a variety of maturities thus automatically providing
a term structure for each underlying name. They are becoming very liquid
for large corporate bond issuers, their documentation is becoming standard-
ized and unlike corporate bonds they do not require a benchmark bond for
extracting credit spreads.
Currently, there is an explosion of papers using CDS data. One early con-
tribution is Blanco et al. (2005) who among other things study lead/lag
relationships between CDS premia and corporate bond spreads on a sample
of European investment grade names. They find evidence that CDS con-
tracts lead corporate bonds. Longstaff et al. (2005) study the size of the CDS
spread compared to corporate bond spreads measured with respect to differ-
ent benchmark riskless rates. Assuming that the CDS premium represents
pure credit risk they are then able to take out the credit risk component of
corporate bonds and ask to what extent liquidity-related measures influence
the residual spread on corporate bonds.
Credit Risk Modeling 795

5 Corporate Bond Spreads and Bond Returns

The current price of a corporate bond in the Merton model - even under risk
neutrality - is smaller than the price of a default-free bond. Therefore, the
yield spread is positive even when there is risk neutrality. This part of the
corporate bond spread is the expected loss component. Empirically, corporate
spreads are found to be larger than the expected loss component, and in fact
they are apparently so much larger that it is questioned whether reasonable
assumptions on risk premia for default can explain the remainder. This is
the essence of the credit risk puzzle. How can actual spreads be so much
larger than the expected loss component? Roughly, potential contributions
to the corporate spread can be divided into the expected loss component,
components due to priced market risk factors in corporate bonds and other
factors, such as taxes (in the US coupons on corporate bonds are taxed at the
state level whereas Treasury bond coupons are not), a liquidity premium on
corporate bonds, and the choice of riskless benchmark (is the Treasury rate
the appropriate benchmark to use?). Early papers pointing to the difficulty of
structural models in explaining spreads are Jones et al. (1984) and Sarig and
Warga (1989). Newer papers attempting to decompose spreads in structural
model settings along the dimensions mentioned above include Huang and
Huang (2003) and Eom et al. (2003). Many papers study spreads in time
series and/or regression frameworks where inspiration on relevant covariates
to include come from form structural models, including Elton et al. (2001)
and Collin-Dufresne et al. (2001). A consensus seems to be building that the
Treasury rate is not an appropriate benchmark in US markets for defining a
riskless rate and using a rate closer to the swap rate at least removes part of
the credit risk puzzle. Using the swap rate as riskless benchmark also brings
credit spreads measured from CDS contracts closer to spreads measured from
corporate bonds as shown in Longstaff et al. (2005). Still, there is no definitive
answer yet to what fraction of credit spreads are in fact explained by default-
related factors.

6 Credit Risk Correlation

Dependence of default events is a key concern of regulators who are looking

into issues of financial stability. Performing empirical studies on dependence
based solely on events, similar to the basic default studies, is difficult since
the number of defaults is fairly limited. Fortunately, a very large market of
Collateralized Debt Obligations has emerged and the pricing of securities
in this market is intimately linked to correlation. This therefore allows us
to analyze market implied correlation. A CDO is an example of an asset
backed security in which the collateral consists of loans or bonds, and where
securities issued against the collateral are prioritized claims to the cash flow of
796 D. Lando

the collateral. The lowest priority claim, the so-called equity tranche, is most
sensitive to default in the underlying pool and the highest priority claim, the
senior tranche, is strongly protected against default. This closely resembles
how equity, junior debt and senior debt are prioritized claims to a firm’s
assets, but there are often 5-7 different ’layers’ in the CDO tranches.
There are roughly speaking three approaches to pricing CDOs.
1. In the copula based approach one takes as given the marginal default in-
tensities of the individual loans in the collateral pool and defines a joint
distribution of default by applying a copula function, i.e. a device for
collecting a family of marginal distributions into a joint distribution pre-
serving the marginal distributions. Often the loans are actually given the
same default intensity and the copula function is then chosen from a para-
metric class of copulas attempting to fit the model to observed tranche
prices. A first paper in this area is Li (2000) but see also Schönbucher
(2003).
2. A full modeling approach is taken in Duffie and Gârleanu (2001) where
the default intensities of individual issuers are given a factor structure,
such that the individual intensities are a sum of a common ’factor’ inten-
sity and idiosyncratic intensities. While one can facilitate computations
by working with affine intensity processes, the model still requires many
parameters as inputs, and this is one reason why it is not adapted as
quickly by market participants despite its more appealing structure. One
may also question the implicit assumption of conditional independence
whereby the only dependence that the defaults have is through their com-
mon dependence on the aggregate factor. Conditionally on this factor the
defaults are independent. This rules out direct contagion among names
in the portfolio.
3. In the third approach, the process of cumulative losses is modeled directly
without focus on the individual issues. One can impose simple jumps
to accommodate one default at a time or one can choose to work with
possibilities of multiple defaults.
As noted, the choice of modeling here is linked to the issue of the extent
to which defaults are correlated only through their common dependence on
the economic environment or whether there is true contagion. This contagion
could take several forms: The most direct is that defaults cause other defaults
but it might also just be the case that defaults cause an increasing likelihood
of default for other issuers. Das et al. (2004) test whether the correlation
found in US corporate defaults can be attributed to common variation on
the estimated intensity of default for all issuers. By transforming the time-
scale, they test the joint hypothesis that the intensities of default of individual
firms are estimated correctly and that the defaults are conditionally indepen-
dent given the realized intensities, and they reject the joint hypothesis. This
is an indication that contagion events could be at play but the reason for the
rejection could also lie in a mis-specification of the intensities, neglecting for
Credit Risk Modeling 797

example an unobserved common default risk factor, sometimes referred to as

a frailty factor in line with the survival analysis literature. An inaccurately
specified underlying intensity could also be the problem. A proper under-
standing and parsimonious modeling of dependence effects in CDO pricing
remains an important challenge.

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