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Credit Risk Modeling
By Andy Raskin

(Business 2.0) – What's the probability that a firm will default on its debt? That's the hottest question in finance, thanks to the wild popularity of credit default swaps—expected to approach a whopping $5 trillion in nominal value this year. To value a credit swap, you need a guess about the chance of default.

That's why financial institutions spent an estimated $100 million on credit risk modeling this year. In the last 12 months, Standard & Poor's launched a credit-risk modeling tool, as did risk-management consultancy MSCI Barra, and top banks have developed in-house models. Industry leader Moody's KMV draws on the work of Nobel laureate Robert Merton, who attacked the problem by predicting when a firm's assets will fall below liabilities. New models mine correlations between, say, financial ratios and historical defaults. The introduction of Dow Jones iTraxx, a default swap index, is providing data to make models more accurate and also stimulating demand for modelers. Says Stanford University finance professor Darrell Duffie, "Suddenly, every week I get a call from a recruiter looking for a Ph.D. who can do this stuff." — ANDY RASKIN