Portfolio Credit Risk of Default and Spread Widening

Abstract

This paper introduces a new model for portfolio credit risk incorporating default and spread widening in one consistent framework. Credit spreads are modelled by geometric Brownian motions with a dependence structure powered by a t-copula. Their joint evolution drives the spreads widening and triggers defaults, and then the loss can be calculated accordingly. It is a heterogeneous model that takes account of different credit rating and term structure for each underlying spread. This model is applicable to credit risk management, stress test, or to fit into regulatory capital requirements, particularly the Incremental Risk Charge. The procedures of parameter calibration and scenario simulation are provided, and a detailed example is also given to see how this proposed model can be implemented in practice.

Keywords: Portfolio Credit Risk, Stress Test, Economic Capital, Default Risk, Spread Widening Risk, Copula

JEL Classification: G32, G18, C30, C51