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Portfolio credit risk of default and spread widening

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  • Zhao, Hongbiao

Abstract

This paper introduces a new model for portfolio credit risk incorporating default and spread widening in a simple and consistent framework. Credit spreads are modelled by geometric Brownian motions with a dependence structure powered by a t-copula. Their joint evolution drives the spreads widening and triggers defaults, and then the loss can be calculated accordingly. It is a heterogeneous model that takes account of different credit ratings and term structures for each underlying spread. This model is applicable to portfolio credit risk management, stress test, or to fit into regulatory capital requirements. The procedures of parameter calibration and scenario simulation are provided. A detailed example is also given to see how this proposed model can be implemented in practice.

Suggested Citation

  • Zhao, Hongbiao, 2011. "Portfolio credit risk of default and spread widening," LSE Research Online Documents on Economics 43451, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:43451
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    File URL: http://eprints.lse.ac.uk/43451/
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    portfolio credit risk; stress test; economic capital; default risk; spread widening risk; Copula; Basel III;
    All these keywords.

    JEL classification:

    • C30 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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