Modelling and calibration errors in measures of portfolio credit risk

Abstract:

This paper develops an empirical procedure for analyzing the impact of model misspecification and calibration errors on measures of portfolio credit risk. When applied to large simulated portfolios with realistic characteristics, this procedure reveals that violations of key assumptions of the well-known Asymptotic Single-Risk Factor (ASRF) model are virtually inconsequential. By contrast, flaws in the calibrated interdependence of credit risk across exposures, which are driven by plausible small-sample estimation errors or popular rule-of-thumb values of asset return correlations, can lead to significant inaccuracies in measures of portfolio credit risk. Similar inaccuracies arise under erroneous, albeit standard, assumptions regarding the tails of the distribution of asset returns.

JEL classification: G21, G28, G13, C15

Keywords: Correlated defaults, value at risk, multiple common factors, granularity, estimation error, tail dependence, bank capital.