Dynamic Factor analysis of industry sector default rates and implication for Portfolio Credit Risk Modelling

Andrea Cipollini and Giuseppe Missaglia ()

Center for Economic Research (RECent) from University of Modena and Reggio E., Dept. of Economics "Marco Biagi"

Abstract: In this paper we use a reduced form model for the analysis of Portfolio Credit Risk. For this purpose, we fit a Dynamic Factor model, DF, to a large dataset of default rates proxies and macrovariables for Italy. Multi step ahead density and probability forecasts are obtained by employing both the direct and indirect method of prediction together with stochastic simulation of the DF model. We, first, find that the direct method is the best performer regarding the out of sample projection of financial distressful events. In a second stage of the analysis, we find that reduced form Portfolio Credit Risk measures obtained through DF are lower than the one corresponding to the Internal Ratings Based analytic formula suggested by Basel 2. Moreover, the direct method of forecasting gives the smallest Portfolio Credit Risk measures. Finally, when using the indirect method of forecasting, the simulation results suggest that an increase in the number of dynamic factors (for a given number of principal components) increases Portfolio Credit Risk.

Keywords: Dynamic Factor Model; Forecasting; Stochastic Simulation; Risk Management; Banking (search for similar items in EconPapers)
JEL-codes: C32 C53 E17 G21 G33 (search for similar items in EconPapers)
Pages: pages 28
Date: 2007-10
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Dynamic Factor analysis of industry sector default rates and implication for Portfolio Credit Risk Modelling (2007)
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