Credit Risk Management Practice Exam

Which approach uses a stochastic process for modeling credit spreads?

1. Parametric approach

2. Intensity approach

3. Structural approach

4. Jump approach

The correct answer is: Intensity approach

The intensity approach is a method that employs a stochastic process to model credit spreads, which represents the risk of default of a borrower and the associated changes in the yield spread of a credit instrument. In this approach, the default intensity, which gauges the likelihood of a borrower defaulting over time, is modeled as a stochastic variable. This allows for capturing the uncertainty and volatility in credit spreads as they fluctuate due to changing market conditions, economic factors, and borrower-specific events. By using a stochastic process, the intensity approach can simulate various scenarios of credit spread behavior over time, providing a more dynamic framework for understanding and predicting credit risk. It can incorporate features such as time-varying intensities and correlations with other risk factors, enhancing the granularity and realism of credit spread modeling compared to more static approaches. Other approaches mentioned, like the parametric and structural approaches, do not typically utilize stochastic processes in the same way for modeling credit spreads. The jump approach is associated with modeling abrupt changes in asset prices or spreads, but not necessarily through the stochastic processes that characterize the intensity approach.