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Factor models and the credit risk of a loan portfolio

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  • Palombini, Edgardo

Abstract

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

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    6. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Asset correlation; factor models; loss distribution; portfolio credit risk; risk contributions;
    All these keywords.

    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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