Firm Heterogeneity and Credit Risk Diversification

52 Pages Posted: 5 Aug 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: August 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 and idiosyncratic risks and the nature of firm heterogeneity. It documents a rich and complex interaction between the underlying model parameters and the resulting loss distributions. The theoretical results indicate that neglecting heterogeneity in firm returns and/or default thresholds leads to underestimation of expected losses (EL), and its effect on portfolio risk is ambiguous. But once EL is controlled for, neglecting parameter heterogeneity leads to overestimation of risk. These results are verified empirically where it is shown that heterogeneity in the default threshold or unconditional probability of default, measured for instance by a credit rating, is of first order importance in affecting the shape of the loss distribution: including ratings heterogeneity alone results in a more than one-quarter drop in loss volatility and a more than one-half drop in 99.9% VaR, the level to which the risk weights of the New Basel Accord are calibrated.

Keywords: Risk management, correlated defaults, factor models, portfolio choice

JEL Classification: C33, G13, G21

Suggested Citation

Pesaran, M. Hashem and Hanson, Samuel Gregory and Schuermann, Til, Firm Heterogeneity and Credit Risk Diversification (August 2005). CESifo Working Paper Series No. 1531. Available at SSRN: https://ssrn.com/abstract=766324

M. Hashem Pesaran

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 (Contact Author)

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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