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Modelling correlations in credit portfolio risk

Author

Listed:
  • Rosenow, Bernd
  • Weissbach, Rafael

Abstract

A credit portfolio's risk level depends on correlations between latent covariates, such as the probability of default in different economic sectors. Correlations often have to be estimated from relatively short time series, and the resulting estimation error hinders the detection of a signal. This paper suggests a general method of parameter estimation which avoids, in a controlled way, the underestimation of correlation risk. The paper presents empirical evidence to show how, in the framework of the CreditRisk+ model with integrated correlations, this method leads to an increased economic capital estimate. In this way, the limits of detecting the portfolio's diversification potential are adequately reflected.

Suggested Citation

  • Rosenow, Bernd & Weissbach, Rafael, 2010. "Modelling correlations in credit portfolio risk," Journal of Risk Management in Financial Institutions, Henry Stewart Publications, vol. 3(1), pages 16-30, January.
    • Handle: RePEc:aza:rmfi00:y:2010:v:3:i:1:p:16-30
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    More about this item

    Keywords

    credit risk; portfolio risk; estimation risk; correlation matrix; random matrix; Bessel function; C46; C15; C53; G32; G33;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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