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Unbiased Capital Allocation in an Asymptotic Single Risk Factor Model of Credit Risk
Company: Federal Deposit Insurance Corporation
Year Of Publication: 2005
Month Of Publication: February
Pages: 41
Download Count: 783
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Comment Num: 0
Language: EN
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Who Can Read: Free
Date: 7-4-2005
Publisher: Administrator
Summary
This paper derives unbiased capital allocation rules for portfolios in which credit risk isdriven by a single common factor and idiosyncratic risk is fully diversified. The methodologyfor setting unbiased capital allocations is developed in the context of the Black-Scholes-Merton (BSM) equilibrium model. The methodology is extended to develop an unbiasedcapital allocation rule for the Gaussian ASRF structural model of credit risk. Unbiasedcapital allocations are shown to depend on yield to maturity as well as probability of default,loss given default, and asset correlations. Unbiased capital allocations are compared tocapital allocations that are set equal to unexpected loss in a Gaussian credit loss model—anapproach that is widely applied in the banking industry and used to set minimum bankregulatory capital standards under the Basel II Internal Ratings Based (IRB) approach. Theanalysis demonstrates that the Gaussian unexpected loss approach substantiallyundercapitalizes portfolio credit risk relative to an unbiased capital allocation rule. Theresults include a suggested correction for the IRB capital assignment function. The correctedcapital rule calls for a substantial increase in minimum capital requirements over the existingBasel II IRB regulatory capital function
Author(s)
Kupiec, Paul Sign in to follow this author
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