Portfolio losses in factor models: term structures and intertemporal loss dependence

Leif Andersen

Journal of Credit Risk

Abstract: ABSTRACT Due to their computational efficiency, simple factor models remain popular in the pricing of credit portfolio derivatives. In this paper, we continue the elaboration on the fundamental structure of factor models initiated in Andersen and Sidenius (2005), with a special focus on term structure effects. We describe a number of techniques to understand, and to improve control over, portfolio loss distribution term structures and intertemporal loss correlation. As part of our analysis, we introduce an extension of the RFL model of Andersen and Sidenius (2004/05) to incorporate jumps in the systematic factor and in firm residuals. We also numerically test the dependence of forward-starting synthetic CDOs on the correlation of losses across time. Finally, our analysis highlights the fact that several of the models suggested in the literature are essentially equivalent.

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