Managing Credit Risk with Credit Derivatives

Bernard Gilroy and Udo Broll

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Banking firm; asset/liability management; credit risk; credit derivatives; dynamic hedging. (search for similar items in EconPapers)
JEL-codes: E0 E4 E5 (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (1)

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