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CREDIT RISK - Coggle Diagram

- - - - Equity = Call option on firm assets.
      - Default when: Firm Value < Debt at maturity.
      - Inputs: Firm value, volatility, debt.
      - Distance to Default (DD) → Expected Default Frequency (EDF)
      - Strength: Links default to firm fundamentals.
      - Weakness: Assumes default only at maturity.
  - - - Improves Merton by allowing early default.
      - Default when firm value crosses a time-dependent barrier.
      - Includes: Covenants, subordination, stochastic interest rates.
      - More realistic but complex.
  - - - VaR-based approach for credit risk.
      - Uses rating transition matrices to measure rating migration.
      - Steps:
      - Estimate credit exposure.
      - Simulate rating migration using copulas.
      - Compute portfolio Credit VaR (loss distribution).