Macroeconomic Dynamics and Credit Risk: A Global Perspective

by M. Hashem Pesaran of the University of Cambridge & USC,
Til Schuermann of the Federal Reserve Bank of New York & Wharton University,
Björn-Jakob Treutler of Mercer Oliver Wyman & WHU, and
Scott M. Weiner of the University of Oxford

April 12, 2005

Abstract: This paper presents a new approach to modeling conditional credit loss distributions. Asset value changes of firms in a credit portfolio are linked to a dynamic global macroeconometric model, allowing macro effects to be isolated from idiosyncratic shocks from the perspective of default (and hence loss). Default probabilities are driven primarily by how firms are tied to business cycles, both domestic and foreign, and how business cycles are linked across countries. We allow for firm-specific business cycle effects and the heterogeneity of firm default thresholds using credit ratings. The model can be used, for example, to compute the effects of a hypothetical negative equity price shock in South East Asia on the loss distribution of a credit portfolio with global exposures over one or more quarters. We show that the effects of such shocks on losses are asymmetric and non-proportional, reflecting the highly non-linear nature of the credit risk model.

JEL Classification: C32, E17, G20.

Keywords: Risk management, economic interlinkages, loss forecasting, default correlation.

Published in: Journal of Money, Credit and Banking, Vol. 38, No. 5, (August 2006), pp. 1211-1261.

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