Incorporating severity variations into credit risk

Peter Bürgisser, Alexandre Kurth and and Armin Wagner

Journal of Risk

Abstract: ABSTRACT The authors present an approach to modeling credit risk that incorporates the risk of counterparty default and the risk of devaluation of the collateral. The framework is based on a segmentation by industry and collateral type. The systematic risk in both drivers is taken into account by volatilities within and by correlations between the segments. A simple formula is derived for the variance of the loss distribution and an algorithm to compute this distribution is described. Moreover, it is shown that, in the limit of a large portfolio, the loss distribution directly mirrors the assumptions on the economy and depends on the portfolio structure only through the expected loss distribution across the segments.

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