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Default probabilities and default correlations under stress

Natalie Packham, Michael Kalkbrener and Ludger Overbeck

No 211, Frankfurt School - Working Paper Series from Frankfurt School of Finance and Management

Abstract: We investigate default probabilities and default correlations of Merton-type credit portfolio models in stress scenarios where a common risk factor is truncated. The analysis is performed in the class of elliptical distributions, a family of light-tailed to heavy-tailed distributions encompassing many distributions commonly found in financial modelling. It turns out that the asymptotic limit of default probabilities and default correlations depend on the max-domain of the elliptical distribution's mixing variable. In case the mixing variable is regularly varying, default probabilities are strictly smaller than 1 and default correlations are in (0; 1). Both can be expressed in terms of the Student t-distribution function. In the rapidly varying case, default probabilities are 1 and default correlations are 0. We compare our results to the tail dependence function and discuss implications for credit portfolio modelling.

Keywords: financial risk management; credit portfolio modelling; stress testing; elliptic distribution; max-domain (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:fsfmwp:211

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