Topics for Credit risk with applications to banking

The contingent claim approach to pricing corporate debt

The Merton model and its extensions. The risk structure of interest rates. The Black-Cox model.  The Leland model. Implications for credit spreads. Estimating asset value and asset volatility. Use in default probability estimation.  Leverage, systematic risk, and risk and return of equity and bonds.  Applications to bank capital structure, including the discussion of cost of capital for banks.

The contingent claim approach to modeling loan portfolios. Understanding CDOs

Merton’s model and Vasicek’s model of loan portfolios. Correlation in loan portfolios. The mixed binomial model, Large Homogeneous Portfolio approximation, application to pricing CDO tranches, the Vasicek model (Gaussian copula). Motives behind securitizations. The Basel formula for capital requirements.  Bank regulation and securitization.   Securitization and systemic risk. Tranching and rating. The risk in resecuritizations

Intensity models. Credit Default Swaps  

Intensity models of default. Pricing credit risky securities in the Cox process setting. Recovery assumptions. Credit default swaps. CDS premia and their relation to corporate bond spreads. Upfront payment. Settlement. The shape of the term structure of credit spreads. Risk premia (jump-to-default risk versus compensation for variation in spreads). The CDS -bond basis.  

Liquidity

Liquidity components of credit spreads. Proxies for liquidity. The riskless rate and the safe asset premium. Swap rates and credit risk. The LIBOR-OIS spreads. New reference rates. Incomplete information and credit spreads. The credit spread puzzle.

Trading and credit

Trading functions. Accounting and capital for trading. Trading frictions. Margin-based asset pricing. XVAs (CVA, DVA,…). 

FX and credit

Yields and currency denomination. Quanto spreads. FX swaps, Cross currency basis swaps. Bank funding and FX swaps.

The students learn the key techniques for pricing credit risky securities and apply the methods to banking.

Grades are based on the final exam.

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