the web's biggest credit risk modeling resource.

Credit Jobs

Home Glossary Links FAQ / About Site Guide Search


Submit Your Paper

In Rememberance: World Trade Center (WTC)

Export citation to:
- Text (plain)
- BibTeX

Exact and Efficient Simulation of Correlated Defaults

by Kay Giesecke of the Stanford University,
Hossein Kakavand of the Perot Group,
Mohammad Mousavi of the Stanford University, and
Hideyuki Takada of the Mizuho-DL Financial Technology

November 2010

Abstract: Correlated default risk plays a significant role in financial markets. Dynamic intensity-based models, in which a firm default is governed by a stochastic intensity process, are widely used to model correlated default risk. The computations in these models can be performed by Monte Carlo simulation. The standard simulation method, which requires the discretization of the intensity process, leads to biased simulation estimators. The magnitude of the bias is often hard to quantify. This paper develops an exact simulation method for intensity-based models that leads to unbiased estimators of credit portfolio loss distributions, risk measures, and derivatives prices. In a first step, we construct a Markov chain that matches the marginal distribution of the point process describing the binary default state of each firm. This construction reduces the original estimation problem to one involving a Markov chain expectation. In a second step, we estimate the Markov chain expectation using a simple acceptance/rejection scheme that facilitates exact sampling. To address rare event situations, the acceptance/rejection scheme is embedded in an overarching selection/mutation scheme, in which a selection mechanism adaptively forces the chain into the regime of interest. Numerical experiments demonstrate the effectiveness of the method for a self-exciting model of correlated default risk.

AMS Classification: 60G55, 60J27, 60J75, 90-08, 65C05.

Keywords: portfolio credit risk, Markovian projection, rare-event simulation, acceptance/rejection, selection/mutation

Published in: SIAM Journal on Financial Mathematics, Vol. 1, (November 2010), pp. 868-896.

Books Referenced in this paper:  (what is this?)

Download paper (530K PDF) 29 pages