We investigate the question of whether sophistication in risk management fosters banking stability. We compare a simple banking system which uses an average rating with a sophisticated banking system in which banks are able to assess the default risk of entrepreneurs individually. Both banking systems compete for deposits, loans, and bank equity. While a sophisticated system rewards entrepreneu...

In this paper, we study the inverse first-crossing problem. This problem originates from the Merton’s structural model [7] for credit risk management, derived as follows. Consider a company whose asset value and debt at time t ≥ 0 are denoted by A(t) and D(t) respectively. Assume the following: (1) D(0) ≤ A(0) and the company is in default at a time t > 0 if A(t) < D(t). (2) {A(t)} is a log-nor...

How should fiscal policy be conducted in the presence of default risk? We address this question using a sovereign default model with nominal rigidities. An increase in government spending during a recession stimulates economic activity and reduces unemployment. Because the government lacks commitment to future debt repayments, expansionary fiscal policy increases sovereign spreads, making the f...

In the paper we detail the reduced form or hazard rate method of pricing credit default swaps, which is a market standard. We then show exactly how the ISDA standard CDS model works, and how it can be independently implemented. Particular attention is paid to the accrual on default formula: We show that the original formula in the standard model is slightly wrong, but more importantly the propo...

Various probabilistic techniques, which are used in the modeling of derivative securities (in particular, zero-coupon bonds) that are subject to default risk are presented in a systematic way. A large class of existing models of the defaultable term structure is covered by our analysis, in addition, some new ideas are presented.

A major problem for insuring catastrophic risk is that, as a disaster causes damages to many insureds at the same time, such insurance and in particular reinsurance contracts are often subject to considerable default risk. On the other hand, the securitization of insurance risk, for example via a catastrophe bond, can be designed to completely avoid default risk. In many cases, however, the pay...

We analyze the determinants of government debt under the twin assumptions that governments have limited horizons and default only when government income falls short of debt service requirements. We derive a government’s maximum sustainable debt ratio, that is, the debt ratio chosen by a myopic government whose horizon does not extend beyond its current term in office. Maximum sustainable debt v...

We measure credit risk premia—prices for bearing corporate default risk in excess of expected default losses—using Markit CDS and Moody’s Analytics EDF data. We find dramatic variation over time in credit risk premia, with peaks in 2002, during the global financial crisis of 2008-09, and in the second half of 2011. Even after normalizing these premia by expected default losses, median credit ri...

This paper examines a new model of credit risk measurement, the Variance GammaMerton one, which seems to be adequate for describing single default occurrence and default correlation in turbulent times. It is based on the notion of business time. Business time runs faster than calendar time when the market is very active and a lot of information arrives; it runs at a slower pace than calendar ti...

In a 1999 paper, Freeman proposes a model in which discount window lending and open market operations have different outcomes—an important development because in most of the literature the results of these policy tools are indistinguishable. Freeman’s conclusion that the central bank should absorb losses related to default to provide risk-sharing goes against the concern that central banks shou...