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Aggregating Credit and Market Risk: The Impact of Model Specification

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  • Andre Lucas

    (VU University Amsterdam, and Duisenberg school of finance)

  • Bastiaan Verhoef

    (Royal Bank of Scotland)

Abstract

We investigate the effect of model specification on the aggregation of (correlated) market and credit risk. We focus on the functional form linking systematic credit risk drivers to default probabilities. Examples include the normal based probit link function for typical structural models, or the exponential (Poisson) link function for typical reduced form models. We first show analytically how model specification impacts 'diversification benefits' for aggregated market and credit risk. The specification effect can lead to Value-at-Risk (VaR) reductions in the range of 3 percent to 47 percent, particularly at high confidence level VaRs. We also illustrate the effects using a fully calibrated empirical model for US data. The empirical effects corroborate our analytic results.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 12-057/2/DSF36.

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Date of creation: 31 May 2012
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Handle: RePEc:dgr:uvatin:20120057

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Web page: http://www.tinbergen.nl

Related research

Keywords: risk aggregation; credit risk; market risk; link function; diversification; reduced form models; structural models;

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References

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  2. Lucas, Andre & Klaassen, Pieter & Spreij, Peter & Straetmans, Stefan, 2001. "An analytic approach to credit risk of large corporate bond and loan portfolios," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1635-1664, September.
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  9. Siem Jan Koopman & André Lucas & André Monteiro, 2005. "The Multi-State Latent Factor Intensity Model for Credit Rating Transitions," Tinbergen Institute Discussion Papers 05-071/4, Tinbergen Institute, revised 04 Jul 2005.
  10. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
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  14. Siem Jan Koopman & Andr� Lucas & Robert J. Daniels, 2005. "A Non-Gaussian Panel Time Series Model for Estimating and Decomposing Default Risk," DNB Working Papers 055, Netherlands Central Bank, Research Department.
  15. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
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