Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/87363
Authors: 
Lucas, Andre
Verhoef, Bastiaan
Year of Publication: 
2012
Series/Report no.: 
Tinbergen Institute Discussion Paper 12-057/2/DSF36
Abstract: 
We investigate the effect of model specification on the aggregation of (correlated) market and credit risk. We focus on the functional form linking systematic credit risk drivers to default probabilities. Examples include the normal based probit link function for typical structural models, or the exponential (Poisson) link function for typical reduced form models. We first show analytically how model specification impacts 'diversification benefits' for aggregated market and credit risk. The specification effect can lead to Value-at-Risk (VaR) reductions in the range of 3 percent to 47 percent, particularly at high confidence level VaRs. We also illustrate the effects using a fully calibrated empirical model for US data. The empirical effects corroborate our analytic results.
Subjects: 
risk aggregation
credit risk
market risk
link function
diversification
reduced form models
structural models
JEL: 
G32
G21
C58
Document Type: 
Working Paper

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