Managing Credit Risk: A Method for Targeting and Maintaining a Steady Distance to Default

Correlations between individual firms’ volatilities tend to increase when economy-wide volatility is high. This paper proposes a novel approach to credit risk management through dynamically adjusting companies’ threshold of default. This “synthetic” threshold of default is a function of a proposed credit availability spread. The dynamics of the default threshold allow it to expand with low (and contract with high) system volatility. Furthermore, the proposed credit availability spread may serve as a forward-looking predictive tool, as it signals system-wide credit line disruption likelihood.