Evaluation of Credit Risk Under Correlated Defaults: The Cross-Entropy Simulation Approach

Loretta Mastroeni, Giuseppe D'Acquisto and Maurizio Naldi

No 193, Departmental Working Papers of Economics - University 'Roma Tre' from Department of Economics - University Roma Tre

Abstract: Credit risk, associated to borrowers defaulting on their debts, is an ever growing source of concern for lenders. The presence of correlation among defaults may be described by the t-copula model. However, the typically large number of variables involved calls for a simulation approach. A simulation method, based on the use of the Cross-Entropy (CE) technique, is here proposed as an alternative to non-adaptive Importance Sampling (IS) techniques so far presented in the literature, the main advantage of CE being that it allows to deal easily with a wider range of probability models than ad hoc IS. The method is validated through a comparison of its results with the crude MonteCarlo and the Exponential Twist approaches. The proposed Cross-Entropy technique is shown to provide accurate results even when the sample size is several orders of magnitude smaller than the inverse of the probability to be estimated.

Keywords: Credit risk; Cross-Entropy; Copula models (search for similar items in EconPapers)
JEL-codes: C15 G32 (search for similar items in EconPapers)
Date: 2014-09
New Economics Papers: this item is included in nep-ban, nep-cmp, nep-ecm and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:rtr:wpaper:0193

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