A SIMPLE CONTINUOUS MEASURE OF CREDIT RISK

Abstract

In this paper it is introduced a simple continuous measure of credit risk, associating to each firm a risk parameter related to the firm’s risk neutral default intensity, which may be computed from quoted bondprices, and allows assignment of credit ratings much more adjusted than those offered by rating agencies. Moody’s Investor Services, Standard and Poor’s Corporation and Fitch are commercial high grade rating companies for assessable default risks (high grade means low credit risks or, conversely high probability of future payments). These gradings are accessible through the distance to default measures (Merton Model, 1974). Traditional ratings are of a discrete nature, not usually updated and not implying probability characteristics. The new measure, together with the other ones, are complementary, showing a good rank correlation between the continuous measure and Moody’s ratings. The new parameters are obtained from quoted bond prices and can be considered as the new risk intensity of immediate default. Instantaneous short rates (forward rates, in general) determine this risk measure. The approach of this paper can be used to extract the entire intertemporal default intensity distribution of firms, useful to calculate the expected time to default, to value and manage the prices and risks of credit derivatives.