PROFESSOR: This week, we'll cover several approaches

for quantifying and pricing credit risk.

Credit risk is one of my main research and policy interests,
and I'm looking forward to telling you about it.
We'll start with a statistical approach, where the main focus
is on estimating default and recovery rates for securities
with credit risk.
Those statistics help to explain the credit spread, which
is the difference in promised yields
between safe and credit-sensitive securities
that are otherwise similar.
We'll then turn to the structural approach that
relates both to default and recovery rate
to a stochastic model of an entity's asset value
and a rule for when a default is triggered.
Those models treat default as a put option
and apply options pricing methods
to value default losses.
As we've seen in many other contexts,
a derivative pricing approach can
be implemented very generally using binomial trees.
And if certain assumptions hold, analytical solutions,
most famously the Merton model, can be derived to price default
options.
Finally, we'll discuss credit derivatives like credit default
swaps, whose payoffs depend on the outcome of credit events
and that also can be priced by no-arbitrage principles.