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Monte Carlo Simulation of Economic Capital Requirement And Default Protection Premium

by Amit Kulkarni of the National Institute of Bank Management

September 20, 2006

Abstract: The paper presents a simulation framework for measuring and managing the default risk of a loan portfolio. Through the dependency of counterparty default on a systematic risk factor, we explore the economic capital requirement for a hypothetical credit portfolio. The study employs bivariate standard normal distribution for mapping asset return correlations into default correlations. Monte Carlo simulations are employed to approximate the loss distribution and estimate various risk measures. The analysis performed shows that the Asymptotic Single Risk Factor (ASRF) model is a fast way for generating heavy tailed credit loss distributions. Furthermore, we report complete analytic derivation of Basel II-IRB risk weight functions. The paper also comments on the pricing of single-period Portfolio Default Swaps.

JEL Classification: G13, G21.

Keywords: Credit VaR, Economic Capital, Expected Shortfall, Portfolio Default Swap.

Published in: ICFAI Journal of Bank Management, Vol. 6, No. 2, (May 2007), pp. 19-52.

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