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Managing Credit Risk with Credit Derivatives

  • Gilroy, Bernard Michael
  • Broll, Udo

Given a commercial banking firm facing credit risk we develop a dynamic hedging model where the bank management can use credit derivatives. In a continuous-time framework optimal hedging strategies, deposit and loan decisions and consumption are studied. It is shown that the optimal hedge ratio consists of two elements: a speculative term which is controlled by the risk premium and the bank's risk aversion; and a pure hedge term which depends on the preferences of bank owners. Primarily the purpose of hedging is to stabilize the consumption path through a reduction in the variability of the dynamics of the wealth accumulation. Furthermore, we demonstrate that the asset/liability management is optimal if marginal cost equal marginal revenue for loans and deposits at each instant.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 17678.

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Date of creation: 2005
Date of revision:
Handle: RePEc:pra:mprapa:17678
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  1. Briys, Eric & Solnik, Bruno, 1992. "Optimal currency hedge ratios and interest rate risk," Journal of International Money and Finance, Elsevier, vol. 11(5), pages 431-445, October.
  2. Udo Broll & Gerhard Schweimayer & Peter Welzel, 2004. "Managing Credit Risk With Credit And Macro Derivatives," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 56(4), pages 360-378, October.
  3. Henri Loubergé & Harris Schlesinger, 2005. "Coping with credit risk," Journal of Risk Finance, Emerald Group Publishing, vol. 6(2), pages 118-134, March.
  4. Battermann, Harald L. & Braulke, Michael & Broll, Udo & Schimmelpfennig, Jorg, 2000. "The preferred hedge instrument," Economics Letters, Elsevier, vol. 66(1), pages 85-91, January.
  5. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
  6. Broll, Udo & Chow, Kong Wing & Wong, Kit Pong, 2001. "Hedging and Nonlinear Risk Exposure," Oxford Economic Papers, Oxford University Press, vol. 53(2), pages 281-96, April.
  7. Kit, Pong Wong, 1997. "On the determinants of bank interest margins under credit and interest rate risks," Journal of Banking & Finance, Elsevier, vol. 21(2), pages 251-271, February.
  8. Briys, Eric & Crouhy, Michel & Schlesinger, Harris, 1990. " Optimal Hedging under Intertemporally Dependent Preferences," Journal of Finance, American Finance Association, vol. 45(4), pages 1315-24, September.
  9. Clark, Ephraim, 1997. "Valuing political risk," Journal of International Money and Finance, Elsevier, vol. 16(3), pages 477-490, June.
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