Credit models and the crisis - Damiano Brigo

The recent financial crisis has highlighted the need for bettervaluation models and risk management procedures, betterunderstanding of structured products, and has called into questionthe actions of many financial institutions. It has becomecommonplace to blame the inadequacy of credit risk models, claimingthat the crisis was due to sophisticated and obscure products beingtraded, but practitioners have for a long time been aware of thedangers and limitations of credit models. It would seem that a lackof understanding of these models is the root cause of theirfailures but until now little analysis had been published on thesubject and, when published, it had gained very limited attention.

Credit Models and the Crisis is a succinct but technicalanalysis of the key aspects of the credit derivatives modelingproblems, tracing the development (and flaws) of new quantitativemethods for credit derivatives and CDOs up to and through thecredit crisis. Responding to the immediate need for clarity in themarket and academic research environments, this book follows thedevelopment of credit derivatives and CDOs at a technical level,analyzing the impact, strengths and weaknesses of methods rangingfrom the introduction of the Gaussian Copula model and the relatedimplied correlations to the introduction of arbitrage-free dynamicloss models capable of calibrating all the tranches for all thematurities at the same time. It also illustrates the impliedcopula, a method that can consistently account for CDOs withdifferent attachment and detachment points but not for differentmaturities, and explains why the Gaussian Copula model is stillused in its base correlation formulation.

The book reports both alarming pre-crisis research and marketexamples, as well as commentary through history, using data up tothe end of 2009, making it an important addition to modernderivatives literature. With banks and regulators struggling tofully analyze at a technical level, many of the flaws in modernfinancial models, it will be indispensable for quantitativepractitioners and academics who want to develop stable andfunctional models in the future.