Risk measurement with integrated market and credit portfolio models

Abstract

This paper studies the effect on economic capital from integrating interest rate and credit spread risk into credit portfolio models. By using fixed forward rates, most credit portfolio models currently employed in the banking industry ignore these risk factors. In contrast to previous studies, this paper accounts for correlated transition risk, credit spread risk, interest rate risk and also recovery rate risk. The simulations show that the error made when neglecting the stochastic nature of interest rates or credit spreads is significant, especially for high quality credit portfolios with low correlations between the obligors' asset returns.

An Economic Capital Model Integrating Credit and Interest Rate Risk in the Banking Book

“…They propose a simple two factor model where the default intensity of borrowers is driven by interest rates and an equity price index, which in turn are correlated. Their theoretical framework is backed by strong empirical evidence that interest rate changes impacts on the credit quality of assets (see Duffie et al, 2007, or Grundke, 2005. If papers integrate both risks, they look at the integrated impact of credit and interest rate risk on assets only, for example by modelling bond portfolios without assessing the impact of interest and credit risk on liabilities or off-balance sheet items.…”

Interaction of market and credit risk

“…These include the following: Barnhill and Maxwell (2002) develop a simulation framework in which they relate financial market volatility to firm-specific credit risk and integrate interest rate, interest rate spread, and foreign exchange rate risk into one overall fixed income portfolio risk assessment and argue that this results in improved risk measurement and management. Grundke (2005) accounts for correlated transition risk, credit spread risk, interest rate risk and recovery rate risk also in a simulation framework and finds that the error made in neglecting the stochastic nature of interest rates or credit spreads (as is the case in standard credit portfolio models) when determining economic capital is significant. See also Medova and Smith (2005), who use a structural credit risk model with stochastic interest rates.…”

Aggregating Credit and Market Risk: The Impact of Model Specification

“…In this paper we follow Gründke (2005) and Kupiec (2007), and focus on a large portfolio of corporate bonds to illustrate the key pattern of market and credit risk interaction. Bond, loan, and mortgage portfolios are typically the largest parts of the trading and banking books.…”

“…Our model set-up is closest to that of Barnhill Jr and Maxwell (2002), Gründke (2005), Kupiec (2007), and Böcker and Hillebrand (2008). All these papers illustrate the diversification effects using a portfolio of zero-coupon bonds and a factor structure for the underlying risks.…”

“…Kupiec (2007), by contrast, models the correlation between default risk and market risk through a one-factor model. A related approach is followed by Gründke (2005), who directly relates default risk to a systematic credit and interest rate risk factor. In addition, the interaction between credit spreads and the short rate is imposed by correlated innovations.…”