Financial Correlation Models – Top-Down Approaches

Gunter Meissner

Imagination is more important than knowledge

– Albert Einstein

Financial credit models, which derive correlated default risk, can be characterised by the way the portfolio default intensity distribution is derived. In the bottom-up models of Chapters 3 to 7, the distribution of the portfolio intensity is an aggregate of the individual entities’ default intensity. In a top-down model the evolution of the portfolio intensity distribution is derived directly, ie, abstracted from the individual entities’ default intensities.

Top-down models are typically applied in practice if (1) the default intensities of the individual entities are unavailable or unreliable; (2) the default intensities of the individual entities are unnecessary (this may be the case when evaluating a homogeneous portfolio such as an index of homogeneous entities); or (3) the sheer size of a portfolio makes the modelling of individual default intensities problematic.

Top-down models are typically more parsimonious, computationally efficient and can often be calibrated better to market prices than bottom-up models. Although seemingly important information – such as the individual entities’ default

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