Accurate allocation of risk capital in credit portfolios

Jan W. Kwiatkowski, D. James Burridge

Abstract

ABSTRACT

We develop a methodology for computing and allocating risk capital for credit portfolios. We use Bayes’ theorem to express the distribution of loss from exposure to individual assets, given a range of portfolio losses, in terms of the distribution of portfolio loss conditional on the individual assets having defaulted. We consider portfolios of corporate and tranched asset-backed securities subject to losses from default and rating downgrades. We use the recursive algorithm of Andersen et al (2003) for discretized losses from credit exposures that are independent conditional on the values of a set of risk factors.