Credit Risk Assessment and Pricing

Diem Ho and Mourad Bara
IBM European Center for Applied Mathematics in Finance, Paris
HoDiem@vnet.ibm.com

Abstract

The credit risk arises when a customer fails to honor his obligation. We shall assess this risk by classifying the customer population into homogeneous segments with different levels of default or contentious rates. Environment variables are taken into account to introduce the forward looking elements into the model. The influential variables to credit risk can then be identified. Default rate is modelled based on the historical data of each segment. The credit risk adjusted cash flow can be generated. We use a financial non-arbitrage model to calculate the credit spread of each segment from its forecasted cash flow. Stochastic simulation can be used to generate the cash flow if necessary. The credit risk adjusted cash flow provides better measures of duration and convexity for risk management. With the credit spread, the real return of each segment can be calculated. Optimization can help the management in its strategic decision to meet the risk/return objective. The calculated spread for each segment can be used to personalize loans given to different customer profiles.