Managing Credit Risk with Credit Derivatives

University of Paderborn Working No. 84

19 Pages Posted: 16 May 2008

See all articles by Udo Broll

Udo Broll

Dresden University of Technology - Faculty of Economics and Business Management

Bernard Michael Gilroy

University of Paderborn - Faculty of Business Administration, Economics and Business Computing

Elmar Lukas

Otto-von-Guericke University Magdeburg, Faculty of Economics and Management - Chair in Financial Management and Innovation Finance

Date Written: July 2005

Abstract

Credit risk is one of the most important forms of risk faced by national and international banks as financial intermediaries. Managing this kind of risk through selecting and monitoring corporate and sovereign borrowers and through creating a diversified loan portfolio has always been one of the predominant challenges in bank management. The aim of our study is to examine how a risky loan portfolio affects optimal bank behavior in the loan and deposit markets, when derivatives to hedge credit risk are available. In a stochastic continuous-time framework a hedging model is developed where the bank management can use derivatives to hedge credit risk. Optimal loan, deposit and hedging strategies are then studied. It is shown that the magnitude and the direction of hedging are determined by the bank manager' s preferences, the corresponding risk premium and the variance of the loan rate and its hedging instrument respectively.

Keywords: banking firm, credit risk, credit derivatives, hedging

JEL Classification: G11, G21, L10

Suggested Citation

Broll, Udo and Gilroy, Bernard Michael and Lukas, Elmar, Managing Credit Risk with Credit Derivatives (July 2005). University of Paderborn Working No. 84, Available at SSRN: https://ssrn.com/abstract=1133872 or http://dx.doi.org/10.2139/ssrn.1133872

Udo Broll

Dresden University of Technology - Faculty of Economics and Business Management ( email )

Mommsenstrasse 13
Dresden, D-01062
Germany

Bernard Michael Gilroy

University of Paderborn - Faculty of Business Administration, Economics and Business Computing ( email )

Warburger Str. 100
D-33098 Paderborn
Germany

Elmar Lukas (Contact Author)

Otto-von-Guericke University Magdeburg, Faculty of Economics and Management - Chair in Financial Management and Innovation Finance ( email )

Universitaetsplatz 2
Postfach 4120
Magdeburg, 39106
Germany
+49 391 67 18934 (Phone)
+49 391 67 18007 (Fax)

HOME PAGE: http://www.ifm.ovgu.de

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