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Calibrating the CreditMetrics™ Correlation Concept: Empirical evidence from Germany

by Lutz Hahnenstein of the IKB Deutsche Industriebank

July 31, 2003

Introduction: Among the major challenges of credit risk measurement is the issue of modelling the joint default behaviour in a portfolio of fixed-income securities, e.g. corporate bonds or loans. Ignoring the impact of up- or downgrades in either the rating agencies' external or banks' own internal rating systems on the securities' market values and focusing instead on a hold-to-maturity point of view, a proper credit risk measurement must, in principle, quantify the probabilities of joint default events across all obligors for the relevant risk horizon. Rooted in accounting practice, the time horizon in credit risk models is usually one year.

JEL Classification: G11, G21.

Keywords: credit portfolio, default risk, asset correlation, obligor specific volatility, factor model, idiosyncratic risk

Published in: Financial Markets and Portfolio Management, Vol. 18, No. 4. (December 2004), pp. 358-381.

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Related reading: CreditMetrics™ -- Technical Document