A simple multifactor "factor adjustment" for the treatment of credit capital diversification

Juan Carlos Garcia Cespedes, Juan Antonio de Juan Herrero, Alex Kreinin, Dan Rosen

Abstract

ABSTRACT

We present a simple adjustment to the single-factor credit capital model, which recognizes the diversification from a multifactor model. We introduce the concept of a diversification factor at the portfolio level, and show that it can be expressed as a function of two parameters that broadly capture the sector concentration and the average cross-sector correlation. The model further supports an intuitive capital allocation methodology through the definition of marginal diversification factors at the sector or obligor level. We estimate the diversification factor for a family of models, and show that it can be expressed in parametric form or tabulated for potential regulatory applications and risk management. As a risk management tool, it can be used to understand concentration risk, capital allocation and sensitivities, stress testing, as well as to compute “real-time” marginal risk.