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Asset Correlations and Credit Portfolio Risk: An empirical analysis

by Klaus Düllmann of Deutsche Bundesbank,
Martin Scheicher of the European Central Bank, and
Christian Schmieder of the European Investment Bank

September 2007

Abstract: We estimate asset correlations from monthly time series of Moody'sKMV asset 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.

JEL Classification: G21, C15.

Keywords: Asset correlations, sector concentration, credit portfolio risk.

Published in: Journal of Credit Risk, Vol. 4, No. 2, (Summer 2008), pp. 37-62.

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