Firm Heterogeneity and Credit Risk Diversification
52 Pages Posted: 5 Aug 2005
Date Written: August 2005
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: Suggested Citation