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The Journal of Fixed Income

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Primary Article

Modeling Forward Credit Risk — An Option Approach

Cho Hoi. Hui
The Journal of Fixed Income Fall 1999, 9 (2) 54-61; DOI: https://doi.org/10.3905/jfi.1999.319260
Cho Hoi. Hui
A senior manager in the banking policy department at the Hong Kong Monetary Authority in Hong Kong.
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Abstract

A new Capital Accord recently proposed by the Basle Committee on banking supervision raises the question of how to measure forward credit risk capital charges arising from maturity–mismatched hedges. This article develops a model to measure forward credit risk that is treated as a put option on a firm's asset value with a maturity–mismatched hedge. The hedge is considered a knockout barrier covering part of the put option life. When the firm value breaches the barrier, this triggers the guarantor to provide full protection to the lender. A closed-form formula of this barrier put option is derived and used to calculate forward credit risk premiums. A straight-line method with a premium capital charge and minimum one-year hedge period for treating residual credit risk in maturity mismatches is shown to be conservative and appropriate for the proposed Capital Accord.

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The Journal of Fixed Income
Vol. 9, Issue 2
Fall 1999
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Modeling Forward Credit Risk — An Option Approach
Cho Hoi. Hui
The Journal of Fixed Income Sep 1999, 9 (2) 54-61; DOI: 10.3905/jfi.1999.319260

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Modeling Forward Credit Risk — An Option Approach
Cho Hoi. Hui
The Journal of Fixed Income Sep 1999, 9 (2) 54-61; DOI: 10.3905/jfi.1999.319260
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  • The Effect of Credit Ratings on Credit Default Swap Spreads and Credit Spreads
  • Using Credit Derivatives to Compute Marketwide Default Probability Term Structures
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Show more Primary Article
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