Aggregating Credit and Market Risk: The Impact of Model Specification

Tinbergen Institute Discussion Paper 12-057/2/DSF36

33 Pages Posted: 2 Jun 2012  

Andre Lucas

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

Bastiaan Verhoef

affiliation not provided to SSRN

Date Written: May 29, 2012

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.

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

JEL Classification: G32, G21, C58

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

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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