Journal of Risk

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Evaluation of credit risk of a portfolio with stochastic interest rate and default processes

Masaaki Kijima, Yukio Muromachi

ABSTRACT

This paper proposes a new simulation model to evaluate the credit risk of a portfolio consisting of interest rate sensitive assets. The model is distinguished from existing risk valuation models, such as CreditMetrics and CREDITRISK+, by the following features: (i) the dynamics of the default-free interest rates, as well as the default processes of defaultable assets, are described by stochastic differential equations; and (ii) the prices of assets are evaluated by the single risk-neutral valuation framework. It is then possible to evaluate not only the credit risk but also the market risk of the portfolio in a synthetic manner. A Gaussian model is developed to reduce computational complexity in simulation. Through extensive numerical experiments, it is observed that the distribution of the future portfolio value subject to credit risk is often nonunimodal.

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