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Factor models and the credit risk of a loan portfolio


  • Palombini, Edgardo


Factor models for portfolio credit risk assume that defaults are independent conditional on a small number of systematic factors. This paper shows that the conditional independence assumption may be violated in one-factor models with constant default thresholds, as conditional defaults become independent only including a set of observable (time-lagged) risk factors. This result is confirmed both when we consider semi-annual default rates and if we focus on small firms. Maximum likelihood estimates for the sensitivity of default rates to systematic risk factors are obtained, showing how they may substantially vary across industry sectors. Finally, individual risk contributions are derived through Monte Carlo simulation.

Suggested Citation

  • Palombini, Edgardo, 2009. "Factor models and the credit risk of a loan portfolio," MPRA Paper 20107, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:20107

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    References listed on IDEAS

    1. Lopez, Jose A., 2004. "The empirical relationship between average asset correlation, firm probability of default, and asset size," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 265-283, April.
    2. 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 449-470, May.
    3. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    4. Dietsch, Michel & Petey, Joel, 2004. "Should SME exposures be treated as retail or corporate exposures? A comparative analysis of default probabilities and asset correlations in French and German SMEs," Journal of Banking & Finance, Elsevier, vol. 28(4), pages 773-788, April.
    5. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
    6. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119.
    7. Paul Glasserman & Jingyi Li, 2005. "Importance Sampling for Portfolio Credit Risk," Management Science, INFORMS, vol. 51(11), pages 1643-1656, November.
    8. Chunsheng Zhou, 1997. "Default correlation: an analytical result," Finance and Economics Discussion Series 1997-27, Board of Governors of the Federal Reserve System (U.S.).
    9. Hamerle, Alfred & Liebig, Thilo & Scheule, Harald, 2004. "Forecasting Credit Portfolio Risk," Discussion Paper Series 2: Banking and Financial Studies 2004,01, Deutsche Bundesbank.
    10. Nikola A. Tarashev & Haibin Zhu, 2006. "The pricing of portfolio credit risk," BIS Working Papers 214, Bank for International Settlements.
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    More about this item


    Asset correlation; factor models; loss distribution; portfolio credit risk; risk contributions;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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