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Tail behaviour of credit loss distributions for general latent factor models

  • Andre Lucas
  • Pieter Klaassen
  • Peter Spreij
  • Stefan Straetmans

Using a limiting approach to portfolio credit risk, we obtain analytic expressions for the tail behavior of credit losses. To capture the co-movements in defaults over time, we assume that defaults are triggered by a general, possibly non-linear, factor model involving both systematic and idiosyncratic risk factors. The model encompasses default mechanisms in popular models of portfolio credit risk, such as CreditMetrics and CreditRisk+. We show how the tail characteristics of portfolio credit losses depend directly upon the factor model's functional form and the tail properties of the model's risk factors. In many cases the credit loss distribution has a polynomial (rather than exponential) tail. This feature is robust to changes in tail characteristics of the underlying risk factors. Finally, we show that the interaction between portfolio quality and credit loss tail behavior is strikingly different between the CreditMetrics and CreditRisk+ approach to modeling portfolio credit risk.

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Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

Volume (Year): 10 (2003)
Issue (Month): 4 ()
Pages: 337-357

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Handle: RePEc:taf:apmtfi:v:10:y:2003:i:4:p:337-357
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  1. Lucas, André & Klaassen, Pieter & Spreij, Peter, 1999. "An analytic approach to credit risk of large corporate bond and loan portfolios," Serie Research Memoranda 0018, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics.
  2. Michael B. Gordy, 1998. "A comparative anatomy of credit risk models," Finance and Economics Discussion Series 1998-47, Board of Governors of the Federal Reserve System (U.S.).
  3. Anil Bangia & Francis X. Diebold & Til Schuermann, 2000. "Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing," Center for Financial Institutions Working Papers 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. Mark Carey, 1998. "Credit Risk in Private Debt Portfolios," Journal of Finance, American Finance Association, vol. 53(4), pages 1363-1387, 08.
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