Credit Risk: Taking Fluctuating Asset Correlations into Account

22 Pages Posted: 16 Jun 2016

See all articles by Thilo Schmitt

Thilo Schmitt

University of Duisburg-Essen

Rudi Schäfer

University of Duisburg-Essen

Thomas Guhr

University of Duisburg-Essen

Date Written: September 02, 2015

Abstract

In structural credit risk models, default events and the ensuing losses are both derived from asset values at maturity. Hence, it is of the utmost importance to choose a distribution for these asset values that is in accordance with empirical data. At the same time, it is desirable to still preserve some analytical tractability. We achieve both goals by putting forward an ensemble approach for asset correlations. Consistent with the data, we view them as fluctuating quantities for which we may choose the average correlation as homogeneous. Thereby, we can reduce the number of parameters to two, the average correlation between assets and the strength of the fluctuations around this average value. Yet, the resulting asset value distribution describes the empirical data well. This allows us to derive the distribution of credit portfolio losses. With Monte Carlo simulations for the value-at-risk and expected tail loss, we validate the assumptions of our approach and demonstrate the necessity of taking fluctuating correlations into account.

Keywords: nonstationarity, random matrix theory, Merton model, value-at-risk

Suggested Citation

Schmitt, Thilo and Schäfer, Rudi and Guhr, Thomas, Credit Risk: Taking Fluctuating Asset Correlations into Account (September 02, 2015). Journal of Credit Risk, Vol. 11, No. 3, 2015. Available at SSRN: https://ssrn.com/abstract=2795524

Thilo Schmitt (Contact Author)

University of Duisburg-Essen ( email )

Lotharstrasse 1
Duisburg, 47048
Germany

Rudi Schäfer

University of Duisburg-Essen ( email )

Lotharstrasse 1
Duisburg, 47048
Germany

Thomas Guhr

University of Duisburg-Essen ( email )

Lotharstrasse 1
Duisburg, 47048
Germany

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