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Managing Credit Risk with Credit Derivatives

Author

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  • Gilroy, Bernard Michael
  • Broll, Udo

Abstract

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.

Suggested Citation

  • Gilroy, Bernard Michael & Broll, Udo, 2005. "Managing Credit Risk with Credit Derivatives," MPRA Paper 17678, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:17678
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    File URL: https://mpra.ub.uni-muenchen.de/17678/1/MPRA_paper_17678.pdf
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    References listed on IDEAS

    as
    1. Briys, Eric & Crouhy, Michel & Schlesinger, Harris, 1990. " Optimal Hedging under Intertemporally Dependent Preferences," Journal of Finance, American Finance Association, vol. 45(4), pages 1315-1324, September.
    2. Henri LOUBERGÉ, & Harris SCHLESINGER, 2001. "Coping with Credit Risk," FAME Research Paper Series rp36, International Center for Financial Asset Management and Engineering.
    3. 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.
    4. Broll, Udo & Chow, Kong Wing & Wong, Kit Pong, 2001. "Hedging and Nonlinear Risk Exposure," Oxford Economic Papers, Oxford University Press, vol. 53(2), pages 281-296, April.
    5. Battermann, Harald L. & Braulke, Michael & Broll, Udo & Schimmelpfennig, Jorg, 2000. "The preferred hedge instrument," Economics Letters, Elsevier, vol. 66(1), pages 85-91, January.
    6. 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.
    7. Clark, Ephraim, 1997. "Valuing political risk," Journal of International Money and Finance, Elsevier, vol. 16(3), pages 477-490, June.
    8. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-1658, December.
    9. 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.
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    Cited by:

    1. Lakshmi, P., 2016. "Feasibility study of credit risk rating systems in banks," Asian Journal of Empirical Research, Asian Economic and Social Society, vol. 6(12), pages 294-306, December.

    More about this item

    Keywords

    Banking firm; asset/liability management; credit risk; credit derivatives; dynamic hedging.;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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