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2 authors:
All content following this page was uploaded by Chulwoo Han on 31 October 2020.
Chulwoo Han
Capital Markets and Portfolio Research
e-mail: chulwoo@cmpr.co.kr
and
Jangkoo Kang
Korea Advanced Institute of Science and Technology
e-mail: jkkang@business.kaist.ac.kr
1
Abstract
Independent sector assumption in the CreditRisk+ (CSFP (1997))
has been a major obstacle to implementing the model. Attempts to
overcome this limitation have not gained much success. This paper pro-
poses an extension of the original model which accommodates a wide
range of sector covariance structures. Existing numerical algorithms
designed for the original model can be reused with little modification.
Case studies show that our model outperforms other CreditRisk+ vari-
ants which allow sector dependency.
A simulation version of our model is also introduced, which in turn
used to find an optimal portfolio allocation based on the work of An-
dersson et al. (2001). Simulation error is very small compared to the
analytic counterpart and the optimization significantly reduces port-
folio credit risk.
2
1 CreditRisk+ for Correlated Sectors
CreditRisk+ model, since its debut in 1997, has received great attention
from both academics and practitioners and extensions and improvements
have been proposed in the literature: Gundlach and Lehrbass (2003) is a
good reference to review recent developments.
CreditRisk+ models probability of default as a linear combination of
gamma-distributed risk factors, also referred to as sectors. The probability
of default conditional on sectors, psi , has the form
K
s
pi = pi w0i + wki Sk
k=1
One major pitfall of the original model is that it assumes Sk are indepen-
dently distributed, which is unreal and impractical: Sectors, being normally
defined as industry sectors, are in general highly correlated, so defining sec-
tors as industries while assuming they are independent would result in an
underestimated credit risk. Though, in theory, correlation between oblig-
ors can be incorporated through sector weights, there is no intuitive way to
determine the weights.
Various approaches addressing this issue have been introduced in the
literature; Bürgisser et al. (1999), Giese (2003), Lesko et al. (2003) to list a
few. However, their ability to incorporate sector correlation is limited to a
narrow range of covariance structure and sector correlation still remains as
a critical implementing issue for the CreditRisk+ model.
Among the models taking sector dependency into account, the hidden
gamma model of Giese (2003) is of particular interest. While other models
usually attempt to incorporate sector dependency by reducing the number
of sectors (e.g., one sector in Akkaya et al. (2003)), the hidden gamma model
adds a common risk factor which affects all sectors and therefore determines
covariance structure of sectors. This is consistent with the economic in-
terpretation of sector correlation, i.e., a macro economic factor affects all
industry sectors and results in correlation. Sectors in the hidden gamma
model has the form
Sk = σk2 (Yk + Ŷ ) (2)
3
where Ŷ ∼ Gamma(θ̂, 1) is the common risk factor, and Yk ∼ Gamma(θk , 1)
are sector specific risk factors, which are independent of Ŷ . Giese (2003)
shows that Equation (1) and σk2 ≥ 0 define the bounds on θ̂:
1
0 ≤ θ̂ ≤ min (3)
k σk2
This condition, which might be overlooked at the first glance, indeed con-
siderably restricts the covariance structure the model can describe. The
correlation coefficient between sector k and l is given by
Assuming that sector k has the largest variance, sector l has the smallest
variance, and σk /σl = 5, we obtain
σl
ρkl ≤ = 0.2.
σk
Thus, if sector variances are rather heterogeneous, the hidden gamma model
becomes viable only when correlations are low.
Note that the hidden gamma model can be restated in the form of the
classical CreditRisk+ model, now with K + 1 sectors:
K+1
s
pi = pi w0i + wki Ŝk (5)
k=1
where1
1 2
Ŝk ∼ Gamma − θ̂, σk , k = 1, . . . , K,
σk2
4
Sk = δk Yk + γk Ŷ , k = 1, . . . , K (6)
where
Yk ∼ Gamma (θk , 1) (7)
Ŷ ∼ Gamma (θ̂, 1) (8)
In this generalized model, Sk is no longer gamma distributed as long as
δk = γk , which is a deviation from a key assumption of the CreditRisk+.
However, it can be seen that by rearranging the equation and newly defining
K + 1 gamma distributed sectors, psi can be written as a linear combination
of the new sectors: K+1
psi = pi w0i + wki Ŝk (9)
k=1
where
Ŝk ∼ Gamma (θk , δk ) , k = 1, . . . , K, (10)
In this sense, the model still lies within the framework of the Cred-
itRisk+. Ŝk , k = 1, . . . , K can be interpreted as sector specific risk factors
and ŜK+1 as a macro economic risk factor. The degree by which a sector is
affected by the macro economic risk factor is determined by δk and γk . From
this point of view, we refer to the model as CreditRisk+ with a common risk
factor or simply as a common factor model, for convenience.
The main advantage of the common factor model is that it enables us to
incorporate sector correlation in a intuitive way and still retains the form of
the original CreditRisk+. This allows us to facilitate many numerical algo-
rithms developed for the CreditRisk+ model with a minor change. Among
them, a generalized version of the numerical procedure in Haaf et al. (2003),
suited to the common factor model, is presented in Appendix A.
The common factor model has the forms of expectation and covariance
matrix
E[Sk ] = δk θk + γk θ̂, (13)
V [Sk ] = δk2 θk + γk2 θ̂, (14)
Cov[Sk , Sl ] = γk γl θ̂. (15)
5
Appropriately choosing the parameters, various covariance structures can
be described by the model.
The parameters are estimated by minimizing this distance under some con-
straints:
min f (θk , δk , γk , θ̂)
θk ,δk ,γk ,θ̂
subject to
δk θk + γk θ̂ = 1, k = 1, . . . , K,
θk ≥ 0, θ̂ ≥ 0, k = 1, . . . , K,
δk ≥ 0, k = 1, . . . , K,
K
wki γk ≥ 0, for each obligor i.
k=1
The first constraint assures E[Sk ] = 1 and the last constraint is from
w(K+1)i ≥ 0.
If variances are considered to be more accurately measured than co-
variances, an alternative would be to exactly match the variances and then
estimate parameters by minimizing the second term of the distance function.
6
The main advantage of the methodology, especially for simulation-based
risk models, is that the optimization problem is formulated as a linear pro-
gramming problem and an optimal solution can be easily obtained. The
formulation of CVaR minimization with various practical constraints can be
found in Han and Park (2006).
To utilize the methodology of Andersson et al. (2001), we need to draw
random samples from the loss distribution defined by the common factor
model. In the CreditRisk+, the loss from obligor i, Xi , is given by
Xi = νi · Di ,
3 Case Studies
In this section, the common factor model is compared to the classical Cred-
itRisk+ model, the hidden gamma model, and the compound gamma model.
Details of the last two models can be found in Giese (2003). Obligor data of
Korea Credit Guarantee Fund (KCGF) was collected for the study. KCGF
is a public financial institution, whose objective is to lead the balanced de-
velopment of the national economy by extending credit guarantee services
for the liabilities of promising enterprises which lack tangible collateral. The
7
CreditRisk+ methodology, which models only default events, is particularly
well suited to the fund since most obligors are small to mid-size businesses,
for which a market-to-market approach is inappropriate. As the instru-
ments are purely based on the obligor’s credit, they are characterized by
high default probabilities and low recovery rates; the average default rate is
approximately 10% and the average recovery rate is 25%.
The fund, as of the end of 2006, has 213,000 obligors. The size of loans
varies from tens of millions to billions summing up to 24,999,480 million
in the local currency (Korean won). The distributions of the probability
of default and exposure across obligors are shown in Figure 1 and 2. The
average size of the exposures is 117 million wons. About fifty percent of the
net exposures are less than 30 million wons and almost eighty percent of the
net exposures are less than 100 million wons. Obligors with large exposures
over 1000 million wons mostly have high credit ratings. Fifty four percent
of the obligors have the probability of default below 10%. The large portion
of the obligors with the probability of default of about 16% is due to many
obligors with no credit ratings which we conservatively mapped to low credit
ratings.
The fund classifies their obligors into six industry sectors; light industry
(LIGHT), heavy industry (HEAVY), construction (CONST), wholesale and
retail (RETAIL), service (SERVICE), and others (OTHERS), and we de-
fined the sectors as such. Each obligor was given a hundred percent weight
to the sector to which it belongs.
The probability of default and the net exposure were provided by the
fund, while the covariance matrix of the sectors was estimated from the 60
monthly observations drawn from the period between January 2001 and De-
cember 2005 (Figure 3). To estimate the covariance matrix, we calculated
the annual default rate of each sector at the end of each month. The de-
fault rate is defined as the number of default events during one year over
the number of obligors at the beginning of the year. In this manner, the
monthly drawn samples are overlapped and gives rise to the autocorrela-
tion problem. It, however, turned out that, in our sample, increasing the
sampling interval to a quarter or a half-year did not significantly alter the
estimate of the covariance matrix. So, we chose to stay with the monthly
observations to maximize the sample size. The sample mean and variance
of each sector are presented in Table 1. The mean values range from 7.7%
(HEAVY) to 12.1% (SERVICE). The volatilities of the sector default rates
range from 15% to 33% of the mean values. The low volatility/mean ratio in
our sample is partly due to the overlapped sampling period. Some authors,
e.g., CSFP (1997), report a higher volatility/mean ratio. The estimated
8
covariance matrix is shown in Table 2. In the table, the upper triangular
part contains covariances normalized by the sample mean, and the lower
triangular part contains corresponding correlation coefficients. Sectors are
very highly correlated, from which we imply that the survival rate of small
and mid-size firms are very sensitive to the macro economic trend.
2
The three models were calibrated by minimizing the distance function in (16). An-
other parameter identification technique is proposed in Giese (2003).
3
The compound gamma model has the form
9
underestimation of the credit risk.
10
sector whose VOL/PD ratio is the greatest, is bounded by the lower bound
in most EL values. Similarly, the weight of RETAIL sector whose VOL/PD
ratio is the second greatest, is also reduced after optimization. By the
nature of the LP problem, many sectors were bounded by the rebalancing
constraints.
We grouped obligors into only six sectors for simplicity. Adding more
classification criteria such as rating will give more control for portfolio re-
balancing and the resulting optimal allocation will improve the risk profile
of the portfolio even more.
4 Concluding Remarks
In this paper, we proposed a simple and intuitive way of incorporating sector
correlation in the CreditRisk+ framework. Our model, referred to as the
common factor model, is very flexible in that it can accommodate various
types of heterogeneous covariance structures. Case studies show that ignor-
ing or falsely estimating sector correlation can significantly underestimate
the credit risk.
Measuring risk is only one stage of the risk management process. Once
risk is measured, the results have to be reflected to portfolio management.
We found the optimal portfolio allocations via the LP method described
in Andersson et al. (2001). For this we drew random samples based on
the model assumptions. Importance sampling deployed in the simulation
procedure remarkably reduces the simulation error. The results suggest
that rebalancing the current portfolio by minimizing the CVaR significantly
improves the portfolio’s risk profile.
We relied on a linear programming approach for the portfolio optimiza-
tion, which inevitably introduces a simulation error. if we could minimize
an analytic form of the CVaR directly, a more accurate result would be
expected. In Kurth and Tasche (2002), analytical forms of the CVaR and
the contributions to it are derived under the CreditRisk+ framework. These
formulas serve as a basis for nonlinear optimization: they can be used as the
objective function and the first-order derivatives. One difficulty in applying
a nonlinear programming approach to the portfolio optimization problem
in our framework is that the loss in the CreditRisk+ model is confined to
integer values. Hopefully, we can find a nonlinear programming algorithm
for minimizing the CVaR within the CreditRisk+ framework in the near
future.
11
References
Akkaya, N., Kurth, A. and Wagner, A., 2003. Incorporating default corre-
lations and severity variations. In: Gundlach and Lehrbass (2003).
Andersson, F., Mausser, H., Rosen, D. and Uryasev, S., 2001. Credit risk
optimization with conditional value-at-risk criterion. Mathematical Pro-
gramming, Series B 89, pp. 273-291, Springer.
Artzner, P., Delbaen, F, Eber, J. and Heath D., 1999. Coherent measures of
risk. Mathematical Finance, 9, pp. 203-228.
Bertsimas, D., Lauprete, G. and Samarov, A., 2002. Shortfall as a risk mea-
sure: properties, optimization and applications. Preprint, Sloan School of
Management, MIT, Cambridge.
Bürgisser, P., Kurth, A., Wagner, A. and Wolf, M., 1999. Integrating corre-
lations. Risk, 12 (7).
Haaf, H., Reiss, O., Schoenmakers, J., 2003. Numerically stable computa-
tion of CreditRisk+. Technical report, Weierstrass Institute for Applied
Analysis and Stochastics.
Han, C. and Park, F. C., 2006. Notes on Credit Risk Portfolio Optimization.
Working paper.
Jobst, N. and Zenios, S., 2001. The tail that wags the dog: integrating credit
risk in asset portfolios. J. Risk Finance, 3(1), pp. 31-43.
12
Lesko M., Schlottmann F. and Vorgrimler S., 2003. Estimation of Sector
Weights from Real-World Data. In: Gundlach and Lehrbass (2003).
13
A Numerical Procedure for Loss Distribution
Consider the generalized form of the CreditRisk+ model
K
psi = pi w0i + wki Sk (18)
k=1
where
Sk ∼ Gamma (αk , βk ) , k = 1, . . . , K. (19)
The probability generating function for loss distribution has the form
GX (z)
N K
N
= exp w0i pi (z νi − 1) − αk ln 1 − βk wki pi (z νi − 1) (20)
i=1 k=1 i=1
K
= exp −Q0 (1) + Q0 (z) − αk ln (1 + βk Qk (1) − βk Qk (z)) (21)
k=1
where
N
Qk (z) = wki pi z νi
i=1
and νi is the net exposure of obligor i, i = 1, . . . , N . Then the numerical
procedure in Haaf et al. (2003) can be rewritten as follows:
for example.
(k)
• Define aj such that
(k)
a0 = 1 + βk Qk (1) (23)
N
(k)
aj = βk wki pi δij , j = 1, . . . , M (24)
i=1
14
(k)
• Define bj such that
(k) (k)
b0 = − log(a0 ) (25)
⎡ ⎤
j−1
(k) 1 ⎣ (k) 1 (k)
bj = (k)
aj + qbq(k) aj−q ⎦ , j = 1, . . . , M (26)
a0 j q=1
• Next, define
K
(k)
c0 = −Q0 (1) + αk b0 (27)
k=1
N
K
(k)
cj = w0i pi δij + αk bj (28)
i=1 k=1
• Finally, define
d0 = exp(c0 ) (29)
j
q
dj = dj−q cq for j ≥ 1. (30)
j
q=1
15
In the above, the right hand side parameters are as defined in the main text
of the paper.
where
N
where
N
(1)
ψ (θ) = pi w0i νi eνi θ , (35)
i=1
⎧ ⎫
⎪ N
⎪
⎪
⎪ ⎪
⎪
⎪
K ⎪
αk βk pi wki νi eνi θ ⎪
⎪
⎨ ⎬
i=1
ψ (2) (θ) = . (36)
⎪ N
⎪
k=1 ⎪
⎪
⎪ νi θ
⎪
⎪
⎪
⎪
⎩ 1 − βk p i wki e − 1 ⎪
⎭
i=1
ψ (θ) = x (37)
θ = max(0, θ) (38)
16
for θ. x is a predetermined portfolio loss, e.g., VaR, around which
samples are drawn. For the CreditRisk+, x can be obtained analyti-
cally.
• Compute τk , k = 1, . . . , K from
N
τk = pi wki eνi θ − 1
i=1
• Draw samples
βk
Sk ∼ Gamma αk , , k = 1, . . . , K.
1 − βk τk
• Draw samples
• Repeat from the third step until you reach the desired number of
iterations.
17
Figure 1: Distribution of the exposures across obligors. Exposures are in
million wons.
18
0.2
0.18
0.16
0.14
0.12
0.1
0.08
0.06 LIGH T
HEAV Y
0.04 C ON ST
RETAIL
0.02 SERVIC E
O THERS
0
0 10 20 30 40 50 60 70
Figure 3: Sector default rate time series. Default rates were monthly ob-
served for five years from January 2001 to December 2005. Obligors were
classified into six industry sectors; light industry (LIGHT), heavy industry
(HEAVY), construction (CONST), wholesale and retail (RETAIL), service
(SERVICE), and others (OTHERS)
19
LIGHT HEAVY CONST RETAIL SERVICE OTHERS
stddev 0.0249 0.0131 0.0131 0.0225 0.0403 0.0270
mean 0.1124 0.0768 0.0881 0.0905 0.1207 0.1152
stddev/mean 0.2212 0.1704 0.1492 0.2484 0.3341 0.2343
HG CG CF
θ θ θ δ γ
LIGHT 11.4857 37.5080 3373.6162 0.0001 0.0740
HEAVY 25.4611 146.9940 56.2176 0.0096 0.0514
CONST 35.9859 Inf 39.6732 0.0175 0.0342
RETAIL 7.2459 25.3440 2541.7952 0.0001 0.0832
SERVICE 0.0000 11.1908 0.0911 0.1453 0.1101
OTHERS 9.2563 30.6307 9.7765 0.0443 0.0632
COMMON 8.9600 37.5080 8.9599
20
LIGHT HEAVY CONST RETAIL SERVICE OTHERS
LIGHT 0.0489 0.0127 0.0098 0.0270 0.0489 0.0241
HEAVY 0.3377 0.0291 0.0058 0.0161 0.0291 0.0143
CONST 0.2956 0.2278 0.0222 0.0123 0.0222 0.0109
RETAIL 0.4922 0.3794 0.3320 0.0617 0.0617 0.0304
SERVICE 0.6620 0.5102 0.4465 0.7436 0.1116 0.0549
OTHERS 0.4643 0.3578 0.3131 0.5215 0.7013 0.0549
(a) Hidden gamma model
LIGHT HEAVY CONST RETAIL SERVICE OTHERS
LIGHT 0.0489 0.0222 0.0222 0.0222 0.0222 0.0222
HEAVY 0.5902 0.0291 0.0222 0.0222 0.0222 0.0222
CONST 0.6745 0.8751 0.0222 0.0222 0.0222 0.0222
RETAIL 0.4050 0.5255 0.6005 0.0617 0.0222 0.0222
SERVICE 0.3011 0.3907 0.4465 0.2681 0.1116 0.0222
OTHERS 0.4294 0.5571 0.6366 0.3823 0.2842 0.0549
(b) Compound gamma model
LIGHT HEAVY CONST RETAIL SERVICE OTHERS
LIGHT 0.0490 0.0341 0.0227 0.0552 0.0730 0.0419
HEAVY 0.9057 0.0289 0.0158 0.0384 0.0508 0.0291
CONST 0.6814 0.6176 0.0226 0.0255 0.0338 0.0194
RETAIL 0.9995 0.9058 0.6815 0.0621 0.0821 0.0472
SERVICE 0.9909 0.8981 0.6757 0.9911 0.1106 0.0624
OTHERS 0.8064 0.7309 0.5499 0.8065 0.7997 0.0550
(c) Common factor model
21
INDEP HG CG CF
EL 1,757,152 1,757,152 1,757,152 1,757,152
50.00% 1,747,171 1,731,366 1,740,626 1,716,367
75.00% 1,888,368 1,947,578 1,952,889 1,984,383
90.00% 2,023,641 2,163,954 2,157,046 2,259,301
95.00% 2,108,487 2,303,922 2,285,262 2,439,720
99.00% 2,275,860 2,588,760 2,538,149 2,811,371
99.90% 2,476,821 2,944,298 2,841,059 3,281,133
22
2,860,000
2,840,000
2,820,000
2,800,000
2,780,000
2,760,000
2,740,000
2,720,000
1,740,000 1,745,000 1,750,000 1,755,000 1,760,000 1,765,000 1,770,000 1,775,000 1,780,000 1,785,000
(a) VaR
3,060,000
3,040,000
3,020,000
3,000,000
2,980,000
2,960,000
2,940,000
2,920,000
2,900,000
1,740,000 1,745,000 1,750,000 1,755,000 1,760,000 1,765,000 1,770,000 1,775,000 1,780,000 1,785,000
(b) CVaR
23
40.000
35.000
30.000
25.000 LIGH T
HEAV Y
C ON ST
20.000
RETAIL
SERVIC E
15.000 O THERS
10.000
5.000
0.000
W0 W1 W2 W3 W4 W5
24
Analytic Simulation Error(%)
EL 1,757,152 1,752,533 -0.263
50.00% 1,716,367 1,733,579 1.003
75.00% 1,984,383 1,990,321 0.299
90.00% 2,259,301 2,253,257 -0.268
95.00% 2,439,720 2,439,275 -0.018
99.00% 2,811,371 2,813,805 0.087
99.90% 3,281,133 3,279,864 -0.039
Table 6: Analytic vs. simulation results of the common factor model. For
importance sampling, pre-specified loss was set to analytically computed
99% percentile loss. Losses were simulated by 10000 iterations. Losses are
in million wons.
25
VOL/PD W0 W1 W2 W3 W4 W5
LIGHT 0.746 14.660 10.262 13.128 15.994 18.519 19.058
HEAVY 0.507 26.783 34.818 34.818 34.818 34.818 34.818
CONST 0.429 10.948 14.233 14.233 14.233 13.320 7.664
RETAIL 1.120 37.381 33.528 30.661 27.795 26.167 26.167
SERVICE 1.983 10.198 7.139 7.139 7.139 7.139 12.256
OTHERS 0.596 0.029 0.020 0.020 0.020 0.038 0.038
26