• Emphasises fixed income instruments rather than loans, where stochastic future exposures are modelled accurately

• Provides a thorough analysis of the pricing and hedging of basket credit derivatives and other credit contingent products

• Examines loans, credit derivatives, interest rate derivatives with risky counterparties and convertible bonds

• Adapts credit derivative modelling techniques in order to price and hedge the credit component in fixed income derivatives

• It provides a practical discussion of market frictions that impact credit trading

• Complex theoretical issues are illustrated with an unusually high number of examples, tables and figures that have been designed with the practitioner in mind

• Proofs and technicalities are discussed in the appendices of each chapter

CONTENTS
Introduction

PART I - CREDIT RISK MANAGEMENT

1 - Overview of Credit Risk
1.1 Components of Credit Risk
1.2 Factors Determining the Credit Risk of a Portfolio
1.3 Traditional Approaches to Managing Credit Risk
1.4 Market Risk versus Credit Risk
1.5 Historical Data
1.6 Example of Default Loss Distribution
1.7 Credit Risk Models
1.8 Conclusion

2 - Exposure Measurement
2.1 Introduction
2.2 Exposure Simulation
2.3 Typical Exposures
2.4 Conclusion

3 - A Framework for Credit Risk Management
3.1 Credit Loss Distribution and Unexpected Loss
3.2 Generating the Loss Distribution
3.3 Example - One Period Model
3.4 Multiple Period Model
3.5 Loan Equivalents
3.6 Conclusion

Appendix
Derivation of the Formulas for Loan Equivalent Exposures

4 - Extensions of the General Framework
4.1 Analytical Approximations to the Loss Distribution
4.2 Monte Carlo Acceleration Techniques
4.3 Extreme Value Theory
4.4 Marginal Risk
4.5 Portfolio Optimisation
4.6 Conclusion

PART II - PRICING AND HEDGING OF CREDIT RISK

5 - Credit Derivatives
5.1 Default Swaps, Asset Swaps and Risky Bonds
5.2 Worst-of and Baskets
5.3 Other Credit Contingent Contracts
5.4 Other Products and Exotics
5.5 Conclusion

6 - Pricing Counterparty Risk in Interest Rate Derivatives
6.1 Introduction
6.2 Overview
6.3 Expected Loss versus Economic Capital
6.4 Portfolio Effect
6.5 Market Variables
6.6 Interest Rate Swaps
6.7 Cross Currency Swaps
6.8 Caps and Floors
6.9 Swaptions
6.10 Portfolio Pricing
6.11 Extensions of the Model
6.12 Hedging
6.13 Conclusion

Appendices
Appendix A - Derivation of the Formula for the Expected Loss on an Interest Rate Swap
Appendix B - The Formula for the Expected Loss on an Interest Rate Cap or Floor
Appendix C - Derivation of the Formula for the Expected Loss on an Interest Rate Swaption (Hull and White Interest Rate Model)
Appendix D - Derivation of the Formula for the Expected Loss on a Cancellable Interest Rate Swap
Appendix E - Market Parameters used for the Computations

7 - Credit Risk in Convertible Bonds
7.1 Introduction
7.2 Basic Features of Convertibles
7.3 General Pricing Conditions
7.4 Interest Rate Model
7.5 Firm Value Model
7.6 Credit Spread Model
7.7 ″Link″ of the two Models
7.8 Hedging of Credit Risk
7.9 Conclusion

Appendices
Appendix A - Firm Value Model - Analytic Pricing Formulae
Appendix B - Derivation of Formulae for Trinomial Tree with Default Branch
Appendix C - Effect of Sub-optimal Call Policy
Appendix D - Incorporation of ″Smile″ in the Firm Value Model

8 - Market Imperfections
8.1 Liquidity Risk
8.2 Discrete Hedging
8.3 Asymmetric Information
8.4 Conclusion

Appendix
1. Credit Swap Valuation Darrel Duffie
2. Practical use of Credit Risk Models in Loan Portfolio and Counterparty Exposure Management Robert A. Jarrow and Donald R. van Deventer
3. An Empirical Analysis of Corporate Rating Migration, Default and Recovery Sean C. Keenan, Lea V. Carty and David T. Hamilton
4. Modelling Credit Migration Bill Demchak
5. Haircuts for Hedge Funds Ray Meadows
6. Generalising with HJM Dmitry Pugachevsky

Glossary

Index

Reviewed by Stuart Turnbull
Canadian Imperial Bank of Commerce
This book provides an excellent guide to credit risk management. Written by risk managers, it is consequently sensitive to the many difficulties that arise in practice. The authors present their arguments in a clear, precise style without getting bogged down in mathematical overkill.

There is a review in chapter 1 of the different methodologies - CreditMetrics, Credit Risk+ and Credit Portfolio View - currently used in credit risk management. The issues of first defining and secondly measuring credit exposure over an arbitrary time horizon are discussed in chapter 2. These two chapters are quite basic and their contents should be common knowledge. Chapter 3 begins to lay out a framework for credit risk management. They first present an expression for the portfolio loss distribution over an arbitrary time horizon. One minor comment is that I would have liked to have seen the issue of intermediate cashflows explicitly addressed.

The authors describe the necessary steps to generate the loss distribution: specification of default probabilities for the individual obligors, correlated defaults, credit migrations and recovery rates. The chapter ends with a discussion of loan equivalents, and an appendix offers a useful sketch of a basic simulation algorithm.

More advanced techniques are presented in chapter 4, starting with analytical approximations of the loss distribution, different Monte Carlo acceleration techniques, and the application of extreme value theory. For risk management, and for allocating capital at the obligor level, it is necessary to be able to accurately measure marginal risk. In practice, the brute force use of Monte Carlo simulation is unsatisfactory, and the authors provide a good discussion of alternative estimation approaches.

For credit portfolios, the breakdown of the subadditivity of value-at-risk is well known. The limitations of VAR form the introduction for the authors to highlight the need for coherent risk measures. The expected shortfall is an example of such a measure, and the authors offer a good explanation of how to measure it. They also discuss its use as a risk measure in portfolio optimisation. The chapter ends with a thorough discussion of credit spread models and their calibration.

Credit derivatives are described in chapter 5 and the pricing of counterparty risk in interest rate derivatives in chapter 6. The pricing of credit risk in convertible bonds is addressed in chapter 7.

Chapter 8, the last, looks at the effects of different market imperfections. The first is that of market liquidity: demand curves are not perfectly elastic. The authors describe a simple but useful model to incorporate market liquidity into the pricing and hedging of an instrument. The second imperfection is that of discrete hedging. The authors never explicitly identify the underlying cause, though presumably the discreteness is caused by transaction costs. The third imperfection is information asymmetry, and the authors present a solution to pricing in the presence of asymmetric information.

The book ends with an appendix containing six papers written by different authors. One irritation is that the professional affiliation of these authors is omitted. Furthermore, no attempt is made to relate the relevance of these papers to the main body of the text or to provide critical comment. Do we really want to value long-dated bonds assuming that interest rates are constant, as is suggested in one of these papers? With accrual accounting, default/no default may be the relevant view, however, as marking-to-market, at least for internal purposes, provides management with useful information, then we should face reality and have stochastic interest rates.

Professional risk managers and academics will benefit from reading this excellent book. It is well written, offers much valuable information and deserves to become a standard reference. The authors have done a great job.