Credit risk is ubiquitous for most financial institutions. The inability of modelling credit risk efficiently has been recognised as one of the major contributing factors to the development of the 2008 financial crisis followed by the European debt crisis in 2010. Realistic models for credit risk is not only in high demand for making profitable investment decisions - new regulatory frameworks specify capital requirements for financial institutions that must be calculated with these models. The price of corporate bonds depends explicitly on the expected risk for default of the underlying company. Modelling segments of bonds is thus one way of modelling credit risk, which is important for any institution or investor with counterparty risk exposure.
This article will discuss why it is important to model credit indices and detail a number of different approaches to this problem.