Journal of Credit Risk

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Asset correlations and credit portfolio risk: an empirical analysis

Klaus Duellmann, Martin Scheicher, Christian Schmieder

ABSTRACT

We estimate asset correlations from monthly time series of Moody’sKMVasset values for around 2,000 European firms from 1996 to 2004. We explore their impact on the value-at-risk (VaR) of credit portfolios in a (single-factor) market model and a (multi-factor) sector model. Our main finding is a complex interaction of asset correlations and default probabilities affecting portfolio risk. Averaging asset correlations on a sector level can substantially underestimate the VaR in a portfolio with heterogeneous borrower size. The VaR of the internal ratings-based model is more stable over time than the VaR of the market model and the sector model.

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