Scope for Credit Risk Diversification

IEPR Working Paper No. 05.18

63 Pages Posted: 14 Mar 2005

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

Samuel Gregory Hanson

Harvard Business School

Til Schuermann

Oliver Wyman

Date Written: February 2005

Abstract

This paper considers a simple model of credit risk and derives the limit distribution of losses under different assumptions regarding the structure of systematic risk and the nature of exposure or firm heterogeneity. We derive fat-tailed correlated loss distributions arising from Gaussian (i.e. non-fat-tailed) risk factors and explore the potential for (and limit of) risk diversification. Where possible the results are generalized to non-Gaussian distributions. The theoretical results indicate that if the firm parameters are heterogeneous but come from a common distribution, for sufficiently large portfolios there is no scope for further risk reduction through active portfolio management. However, if the firm parameters come from different distributions, say for different sectors or countries, then further risk reduction is possible, even asymptotically, by changing the portfolio weights. In either case, neglecting parameter heterogeneity can lead to underestimation of expected losses. But, once expected losses are controlled for, neglecting parameter heterogeneity can lead to overestimation of risk, whether measured by unexpected loss or value-at-risk. We examine the impact of sectoral and geographic diversification on credit losses empirically using returns for firms in the U.S. and Japan across seven sectors and find that ignoring this heterogeneity results in far riskier credit portfolios. Risk, is reduced significantly when parameter heterogeneity is properly taken into account.

Keywords: Risk management, correlated defaults, credit loss distributions, heterogeneity, diversification

JEL Classification: C33, G13, G21

Suggested Citation

Pesaran, M. Hashem and Hanson, Samuel Gregory and Schuermann, Til, Scope for Credit Risk Diversification (February 2005). IEPR Working Paper No. 05.18. Available at SSRN: https://ssrn.com/abstract=681344 or http://dx.doi.org/10.2139/ssrn.681344

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

Samuel Gregory Hanson

Harvard Business School ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

Til Schuermann

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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