The power of the portfolio

To observers, credit portfolio modelling appears particularly dependent upon making approximations. Derivatives traders may study finite difference schemes, but at least the pricing models are finely calibrated to the market. Asset managers might have to estimate their efficient frontiers, but the price data for traded bonds and equities makes this relatively straightforward.

Credit portfolio managers, overseeing hundreds or even thousands of counterparties, have much less to go on. Default and recovery statistics exist, but how should their idiosyncrasies be untangled from the economic cycle when estimating counterparty default probabilities? And how do these probabilities interconnect as part of a big portfolio? The answers to these questions – and their impact on economic capital, asset allocation and hedging policy – can spell the difference between the success