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Gordy Credit Risk Formula and Downgrade Risk

Article Quant Q&A · Author: PalimPalim
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Summary

The document clarifies the scope of the Gordy formula as described through its underlying asymptotic single-risk-factor credit model. The model represents an entity at the horizon as either performing or defaulted, and recognizes a monetary loss when default occurs. On that framing, the formula captures default risk rather than modeling rating downgrades as a separate state that can cause mark-to-market losses.

The answer is brief and provides no derivation, calibration details, or discussion of extensions that include migration risk. Its conclusion applies to the stated two-state default setup; it does not establish how every credit-risk implementation handles downgrades, nor does it address losses from spread changes before maturity.

Key ideas

  • The described Gordy framework uses an asymptotic single-risk-factor credit model.
  • The stated model distinguishes performing entities from defaulted entities at the horizon.
  • Loss is attributed to default in this two-state setup, so downgrade risk is not modeled separately.
  • The document does not cover extensions that represent rating migration or pre-maturity spread losses.

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Fixed incomeRisk managementStatistics
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# Does Gordy Formula measure default risk & downgrade risk?


# Does Gordy Formula measure default risk & downgrade risk?












The Gordy Formula used for measuring Credit Risk as proposed in Basel Rules is based on the asymptotic single risk factor model. It is derived from a Merton Model. The Merton Model only knows to stati, i.e. performing or defaulted.

Is it therefore fair to say that the formula calculates default risk, but not the risk of a rating downgrade which will also lead to a loss until held to maturity?

## Answer by TickaJules (score 1, accepted)

https://quant.stackexchange.com/a/73519

The model (and models like it) seem to suggest an issuer or entity is, by time $T>0$, in one of two states: defaulted or not. Money is lost only on a default.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.