On the Valuation Credit Risk Via Reduced-Form Approach

Abstract

This paper presents the valuation of credit risk via reduced-form approach. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. It is closely tied to the potential return of investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk. Credit risk embedded in a financial transaction, is the risk that at least one of the parties involved in the transaction will suffer a financial loss due to decline in creditworthiness of the counter-party to the transaction or perhaps of some third party. Reduced-form approach is known as intensity-based approach. This is purely probabilistic in nature and technically speaking it has a lot in common with the reliability theory. Here the value of firm is not modeled but specifically the default risk is related either by a deterministic default intensity function or more general by stochastic intensity.