Abstract

http://ssrn.com/abstract=2071582
 
 

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Aggregating Credit and Market Risk: The Impact of Model Specification


Andre Lucas


VU University Amsterdam - Faculty of Economics and Business; Tinbergen Institute

Bastiaan Verhoef


affiliation not provided to SSRN

May 29, 2012

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.

Number of Pages in PDF File: 33

Keywords: risk aggregation, credit risk, market risk, link function, diversification, reduced form models, structural models

JEL Classification: G32, G21, C58

working papers series


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Date posted: June 2, 2012  

Suggested Citation

Lucas, Andre and Verhoef, Bastiaan, Aggregating Credit and Market Risk: The Impact of Model Specification (May 29, 2012). Tinbergen Institute Discussion Paper 12-057/2/DSF36. Available at SSRN: http://ssrn.com/abstract=2071582 or http://dx.doi.org/10.2139/ssrn.2071582

Contact Information

Andre Lucas (Contact Author)
VU University Amsterdam - Faculty of Economics and Business ( email )
De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31 20 598 6039 (Phone)
+31 20 598 6020 (Fax)
HOME PAGE: http://www.feweb.vu.nl
Tinbergen Institute
Roetersstraat 31
Amsterdam, 1018 WB
Netherlands
HOME PAGE: http://www.tinbergen.nl
Bastiaan Verhoef
affiliation not provided to SSRN
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