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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?

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  • $\begingroup$ Can you please add more details, specifically, which formula you refer to? Thanks in advance $\endgroup$
    – Kermittfrog
    Oct 19, 2022 at 7:13

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Reset to default
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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.

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  • $\begingroup$ And what about downgrade ? $\endgroup$
    – Kurt G.
    Oct 18, 2022 at 7:42
  • $\begingroup$ Downgrades are like marking-to-market as you move towards default. So in that sense, this formula doesn't mark-to-market--it just incurs the losses on defaults. $\endgroup$
    – TickaJules
    Oct 19, 2022 at 2:15

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