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Risk Factor Contributions in Portfolio Credit Risk Models

by Dan Rosen of the Fields Institute, and
David Saunders of the University of Waterloo

February 2010

Abstract: Determining contributions to overall portfolio risk is an important topic in risk management. For positions (instruments and sub-portfolios), this problem has been well studied, and a significant theory built, around the calculation of marginal contributions. We consider the problem of determining the contributions to portfolio risk of risk factors. This cannot be addressed through an immediate extension of techniques for position contributions, since the portfolio loss is a nonlinear function of the risk factors. We employ the Hoeffding decomposition of the portfolio loss into a sum of terms depending on the factors. This decomposition restores linearity, but includes terms arising from joint effects of groups of factors. These cross-factor terms provide information to risk managers, since they can be viewed as best hedges of the portfolio loss involving instruments of increasing complexity. We illustrate the technique on multifactor portfolio credit risk models, where systematic factors represent industries, geographical sectors, etc.

JEL Classification: C02, G32.

Keywords: Risk contributions, Risk measures, Portfolio credit risk, Hoeffding decomposition.

Published in: Journal of Banking & Finance, Vol. 34, No. 2, (February 2010), pp. 336-349.

Previously titled: Risk Contributions of Systematic Factors in Portfolio Credit Risk Models

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