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Title:Asset correlations and credit portfolio risk: an empirical analysis PDF Logo
Authors:Düllmann, Klaus
Scheicher, Martin
Schmieder, Christian
Issue Date:2007
Series/Report no.:Discussion Paper, Series 2: Banking and Financial Supervision 2007,13
Abstract:In credit risk modelling, the correlation of unobservable asset returns is a crucial component for the measurement of portfolio risk. In this paper, we estimate asset correlations from monthly time series of Moody's KMV asset values for around 2,000 European firms from 1996 to 2004. We compare correlation and value-atrisk (VaR) estimates in a one-factor or market model and a multi-factor or sector model. Our main finding is a complex interaction of credit risk correlations and default probabilities affecting total credit portfolio risk. Differentiation between industry sectors when using the sector model instead of the market model has only a secondary effect on credit portfolio risk, at least for the underlying credit portfolio. Averaging firm-dependent asset correlations on a sector level can, however, cause a substantial underestimation of the VaR in a portfolio with heterogeneous borrower size. This result holds for the market as well as the sector model. Furthermore, the VaR of the IRB model is more stable over time than the VaR of the market model and the sector model, while its distance from the other two models fluctuates over time.
Subjects:Asset correlations
sector concentration
credit portfolio risk
JEL:C15
G21
Document Type:Working Paper
Appears in Collections:Discussion Paper Series 2: Banking and Financial Studies, Deutsche Bundesbank

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