Tinbergen Institute Discussion Paper 12-057/2/DSF36
33 Pages Posted: 2 Jun 2012
Date Written: May 29, 2012
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.
Keywords: risk aggregation, credit risk, market risk, link function, diversification, reduced form models, structural models
JEL Classification: G32, G21, C58
Suggested Citation: 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: https://ssrn.com/abstract=2071582 or http://dx.doi.org/10.2139/ssrn.2071582