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Scope of Credit Risk Diversification
Year Of Publication: 2005
Month Of Publication: February
Pages: 64
Download Count: 446
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Comment Num: 0
Language: EN
Who Can Read: Free
Date: 1-27-2007
Publisher: Administrator
This paper considers a simple model of credit risk and derives the limit distribution of lossesunder different assumptions regarding the structure of systematic risk and the nature of exposureor 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 resultsindicate 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 portfoliomanagement. However, if the firm parameters come from different distributions, say fordifferent sectors or countries, then further risk reduction is possible, even asymptotically, bychanging the portfolio weights. In either case, neglecting parameter heterogeneity can lead tounderestimation of expected losses. But, once expected losses are controlled for, neglectingparameter heterogeneity can lead to overestimation of risk, whether measured by unexpectedloss or value-at-risk. We examine the impact of sectoral and geographic diversification on creditlosses empirically using returns for firms in the U.S. and Japan across seven sectors and find thatignoring this heterogeneity results in far riskier credit portfolios. Risk, is reduced significantlywhen parameter heterogeneity is properly taken into account.
Hanson, Samuel Sign in to follow this author
Pesaran, M. Hashem Sign in to follow this author
Schuermann, Til Sign in to follow this author
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