Modelling correlations in credit portfolio risk

Bernd Rosenow and Rafael Weissbach
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Bernd Rosenow: Physics Department, Harvard University, Cambridge, MA 02138 and Max-Planck Institute for Solid State Research, 70569 Stuttgart, USA

Journal of Risk Management in Financial Institutions, 2010, vol. 3, issue 1, 16-30

Abstract: A credit portfolio’s risk level depends on correlations between latent covariates, such as the probability of default in different economic sectors. correlations often have to be estimated from relatively short time series, and the resulting estimation error hinders the detection of a signal. this paper suggests a general method of parameter estimation which avoids, in a controlled way, the underestimation of correlation risk. the paper presents empirical evidence to show how, in the framework of the creditrisk+ model with integrated correlations, this method leads to an increased economic capital estimate. in this way, the limits of detecting the portfolio’s diversification potential are adequately reflected.

Keywords: credit risk; portfolio risk; estimation risk; correlation matrix; random matrix; Bessel function; JEL classification: C46; C15; C53; G32; G33 (search for similar items in EconPapers)
JEL-codes: E5 G2 (search for similar items in EconPapers)
Date: 2010
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Persistent link: https://EconPapers.repec.org/RePEc:aza:rmfi00:y:2010:v:3:i:1:p:16-30

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