Credit Models Past and Present

The extension of credit is a display of faith in the future. It involves the exchange of a liquid asset (such as cash) for a documented promise of repayment at a later date. Instruments of credit typically consist of loans, bonds, charge account balances with commercial firms and, latterly, credit default swaps (CDS) and other more complicated financial obligations.¹¹These include structured credit products such as collateralised loan obligations (CLOs), single-tranche collateralised debt obligations (CDOs), credit options, and even counterparty credit risk. A feature of credit instruments is that their expected return profiles are negatively skewed, owing mainly to potential losses from default. That is, one takes on the risk of a low likelihood of a large loss for a more likely steady stream of smaller returns. This chapter will present an historical description of methods developed to analyse the default risk of credit obligors. This first chapter will trace the origins of credit analysis from the fundamental analysis of government bond risk up to the popular structural and risk