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Risk Measurement with Integrated Market and Credit Portfolio Models

by Peter Grundke of the University of Cologne

December 2004

Abstract: This paper studies the effect on economic capital from integrating interest rate and credit spread risk into credit portfolio models. By using fixed forward rates, most credit portfolio models currently employed in the banking industry ignore these risk factors. In contrast to previous studies, this paper accounts for correlated transition risk, credit spread risk, interest rate risk and also recovery rate risk. The simulations show that the error made when neglecting the stochastic nature of interest rates or credit spreads is significant, especially for high quality credit portfolios with low correlations between the obligors' asset returns.

JEL Classification: G21.

Keywords: credit spread risk, interest rate risk, credit portfolio model, VaR.

Published in: Journal of Risk, Vol. 7, No. 3, (Spring 2005), pp. 63-94.

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