Granularity Adjustment for Mark-to-Market Credit Risk Models

44 Pages Posted: 27 Jul 2011

Multiple version iconThere are 2 versions of this paper

Date Written: June 3, 2010

Abstract

The impact of undiversified idiosyncratic risk on value-at-risk and expected shortfall can be approximated analytically via a methodology known as granularity adjustment (GA). In principle, the GA methodology can be applied to any risk-factor model of portfolio risk. Thus far, however, analytical results have been derived only for simple models of actuarial loss, i.e., credit loss due to default. We demonstrate that the GA is entirely tractable for single-factor versions of a large class of models that includes all the commonly used mark-to-market approaches. Our approach covers both finite ratings-based models and models with a continuum of obligor states. We apply our methodology to CreditMetrics and KMV Portfolio Manager, as these are benchmark models for the finite and continuous classes, respectively. Comparative statics of the GA with respect to model parameters in CreditMetrics reveal striking and counterintuitive patterns. We explain these relationships with a stylized model of portfolio risk.

Keywords: Granularity adjustment, idiosyncratic risk, portfolio credit risk, value-at-risk, expected shortfall

Suggested Citation

Gordy, Michael B. and Marrone, James V, Granularity Adjustment for Mark-to-Market Credit Risk Models (June 3, 2010). FEDS Working Paper No. 2010-37. Available at SSRN: https://ssrn.com/abstract=1895495 or http://dx.doi.org/10.2139/ssrn.1895495

Michael B. Gordy (Contact Author)

Federal Reserve Board ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3705 (Phone)

HOME PAGE: http://https://www.federalreserve.gov/econres/michael-b-gordy.htm

James V Marrone

University of Chicago ( email )

1126 E 59th St
Chicago, IL 60637
United States

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