Measuring and managing market, credit and Op risk [54]

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Bullet points include: Firm with assets V at future time T and due to repay D in pure discount debt at time T Payoff to equity: max(V – D , 0), i.e. payoff on call with strike D Payoff to debt: min(D , V) = D + min(0 , V – D) = D – max(D – V , 0) (If V > 0 !), i.e. payoff on safe claim of D minus payoff on a put with strike D So, use equity and liability data to infer level and volatility of a firm’s underlying asset value, V Repeat for multiple firms to estimate correlations of inferred asset values Liability data here refers to accounting data etc. used to quantify firm’s liabilities

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