Financial Risk: Credit Risk, Lecture 1: Alexander Herbertsson

Financial Risk: Credit Risk, Lecture 1
Alexander Herbertsson
Centre For Finance/Department of Economics
School of Economics, Business and Law, University of Gothenburg
E-mail: [email protected]
Financial Risk, Chalmers University of Technology,
G oteborg
Sweden
Slides prepared by Alexander Herbertsson and presented by Prof. Holger Rootzen
November 17, 2011
Alexander Herbertsson (Univ. of Gothenburg) Financial Risk: Credit Risk, Lecture 1 November 17, 2011 1 / 36
Content of lecture
Short discussion of the important components of credit risk
Study dierent static portfolio credit risk models.
Discussion of the binomial loss model
Discussion of the mixed binomial loss model
Study of a mixed binomial loss model with a beta distribution
Study of a mixed binomial loss model with a logit-normal distribution
A short discussion of Value-at-Risk and Expected shortfall
Denition of Credit Risk
Credit risk
the risk that an obligor does not honor his payments
Example of an obligor:
A company that have borrowed money from a bank
A company that has issued bonds.
A household that have borrowed money from a bank, to buy a house
Example of defaults are
A company goes bankrupt.
As company fails to pay a coupon on time, for some of its issued
bonds.
A household fails to pay amortization or interest rate on their loan.
Credit Risk
Credit risk can be decomposed into:
arrival risk, the risk connected to whether or not a default will
happen in a given time-period, for a obligor
timing risk, the risk connected to the uncertainness of the exact
time-point of the arrival risk (will not be studied in this course)
recovery risk. This is the risk connected to the size of the actual loss
if default occurs (will not be studied in this course, we let the
recovery be xed)
default dependency risk, the risk that several obligors jointly
defaults during some specic time period. This is one of the most
crucial risk factors that has to be considered in a credit portfolio
framework.
The coming two lectures focuses only on default dependency risk.
Portfolio Credit Risk is important
Modelling dependence between default events and between credit quality
changes is, in practice, one of the biggest challenges of credit risk models.,
David Lando, Credit Risk Modeling, p. 213.
Default correlation and default dependency modelling is probably the most
interesting and also the most demanding open problem in the pricing of
credit derivatives. While many single-name credit derivatives are very similar
to other non-credit related derivatives in the default-free world (e.g.
interest-rate swaps, options), basket and portfolio credit derivative have
entirely new risks and features.,
Philipp Schonbucher, Credit derivatives pricing models, p. 288.
Empirically reasonable models for correlated defaults are central to the
credit risk-management and pricing systems of major nancial institutions.,
Darrell Due and Kenneth Singleton, Credit Risk: Pricing, Measurement
and Management , p. 229.
Portfolio Credit Risk is important
Portfolio credit risk models dier greatly depending on what types of
portfolios, and what type of questions that should be considered. For
example,
models with respect to risk management, such as credit Value-at-Risk
(VaR) and expected shortfall (ES)
models with respect to valuation of portfolio credit derivatives, such as
CDOs and basket default swaps
In both cases we need to consider default dependency risk, but....
...in risk management modelling (e.g. VaR, ES), the timing risk is ignored,
and one often talk about static credit portfolio models,
...while, when pricing credit derivatives, timing risk must be carefully
modeled (not treated here)
The coming two lectures focuses only on static credit portfolio models,
Literature
The slides for the coming two lectures are rather self-contained, except for some
results taken from Hult & Lindskog.
The content of the lecture today and next Friday is partly based on materials
presented in
Lecture notes by Henrik Hult and Filip Lindskog (Hult & Lindskog)
Mathematical Modeling and Statistical Methods for Risk Management,
see the course-webpage for the link to these notes
Quantitative Risk Management by McNeil A., Frey, R. and Embrechts, P.
(Princeton University Press)
Credit Risk Modeling: Theory and Applications by Lando, D . (Princeton
University Press)
Static Models for homogeneous credit portfolios
Today we will consider the following static modes for a homogeneous
credit portfolio:
The binomial model
The mixed binomial model
To understand mixed binomial models, we give a short introduction of
conditional expectations (p.106-107 in Hult & Lindskog)
After this we look at two dierent mixed binomial models.
We also shortly discuss Value-at-Risk and Expected shortfall
Next lecture we consider a mixed binomial model inspired by the
Merton framework. Furthermore, a contagion model is also treated.
The binomial model for independent defaults
Consider a homogeneous credit portfolio model with m obligors, and where we
each obligor can default up to xed time point, say T. Each obligor have
identical credit loss at a default, say . Here is a constant.
Let X
i
be a random variable such that
X
i
=
_
1 if obligor i defaults before time T
0 otherwise, i.e. if obligor i survives up to time T
(1)
We assume that the random variables X
1
, X
2
, . . . X
m
are i.i.d, that is they
are all independent with identical distribution.
Furthermore P[X
i
= 1] = p so that P[X
i
= 0] = 1 p.
The total credit loss in the portfolio at time T, called L
m
, is then given by
L
m
=
m
i =1
X
i
=
m
i =1
X
i
= N
m
where N
m
=
m
i =1
X
i
thus, N
m
is the number of defaults in the portfolio up to time T.
Since is a constant, we have P[L
m
= k] = P[N
m
= k], so it is enough to
study the distribution of N
m
.
The binomial model for independent defaults, cont.
Since X
1
, X
2
, . . . X
m
are i.i.d with with P[X
i
= 1] = p we conclude that
N
m
=
m
i =1
X
i
is binomially distributed with parameters m and p, that is
N
m
Bin(m, p).
This means that
P[N
m
= k] =
_
m
k
_
p
k
(1 p)
mk
Recalling the binomial theorem (a + b)
m
=
m
k=1
_
m
k
_
a
k
b
mk
we see that
m
k=1
P[N
m
= k] =
m
k=1
_
m
k
_
p
k
(1 p)
mk
= (p + (1 p))
m
= 1
proving that Bin(m, p) is a distribution.
Furthermore, E[N
m
] = mp since
E[N
m
] = E
_
m
i =1
X
i
_
=
m
i =1
E[X
i
] = mp.
0 5 10 15 20 25 30
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
number of defaults
p
r
o
b
a
b
i
l
i
t
y
The portfolio credit loss distribution in the binomial model

bin(50,0.1)
The binomial distribution have very thin tails, that is, it is extremely
unlikely to have many losses (see gure).
For example, if p = 5% and m = 50 we have that P[N
m
8] = 1.2% and
for p = 10% and m = 50 we get P[N
m
10] = 5.5%
The main reason for these small numbers (even for large individual default
probabiltes) is due to the independence assumption. To see this, recall that
the variance of a random variable Var(X) measures the degree of the
deviation of X around its mean, i.e. Var(X) = E
_
(X E[X])
2
_
.
Since X
1
, X
2
, . . . X
m
are independent we have that
Var(N
m
) = Var
_
m
i =1
X
i
_
=
m
i =1
Var(X
i
) = mp(1 p) (2)
where the second equality is due the independence assumption.
Furthermore, by Chebyshevs inequality (see p.105 in Hult & Lindskog) we
have that for any random varialbe X, and any c > 0 it holds
P[|X E[X] | c]
Var(X)
c
2
So if p = 5% and m = 50 we have that Var(N
m
) = 50p(1 p) = 2.375 and
and E[N
m
] = 50p = 2.5 implying that having say, 6 more, or less losses than
expected, is smaller or equal than 6.6%, since by Chebyshevs inequality
P[|N
m
2.5| 6]
2.375
36
= 6.6%
Hence, the probability of having a total number of losses outside the interval
2.5 6, i.e. outside the interval [0, 8.5], is smaller than 6.6%.
In fact, one can show that the deviation of the average number of defaults
in the portfolio,
N
m
m
, from the constant p (where p = E
_
N
m
m
) goes to zero
as m . Thus,
N
m
m
converges towards a constant as m (the law of
large numbers).
Independent defaults and the law of large numbers
By applying Chebyshevs inequality to the random variable
N
m
m
together with
Equation (2) we get
P
_
N
m
m
p
Var
_
N
m
m
_
2
=
1
m
2
Var (N
m
)
2
=
mp(1 p)
m
2
2
=
p(1 p)
m
2
and we conclude that P
_
|
N
m
m
p|
0 as m . Note that this

holds for any > 0.
This result is called the weak law of large numbers, and says that the
average number of defaults in the portfolio, i.e.
N
m
m
, converges (in
probability) to the constant p which is the individual default probability.
One can also show the so called strong law of large numbers, that is
P
_
N
m
m
p when m
_
= 1
and we say that
N
m
m
converges almost surely to the constant p. In these
lectures we write
N
m
m
p to indicate almost surely convergence.
For more on this, see p.105 in Hult & Lindskog.
Independent defaults lead to unrealistic loss scenarios
We conclude that the independence assumption, or more generally, the i.i.d
assumption for the individual default indicators X
1
, X
2
, . . . X
m
implies that
the average number of defaults in the portfolio
N
m
m
converges to the
constant p almost surely.
Given the recent credit crisis, the assumption of independent defaults is
ridiculous. It is an empirical fact, observed many times in the history, that
defaults tend to cluster. Hence, the fraction of defaults in the portfolio
N
m
m
will often have values much bigger than the constant p.
Consequently, the empirical (i.e. observed) density for
N
m
m
will have much
more fatter tails compared with the binomial distribution.
We will therefore next look at portfolio credit models that can produce more
realistic loss scenarios, with densities for
N
m
m
that have fat tails, and which
not implies that the average number of defaults in the portfolio
N
m
m
converges to a constant with probability 1, when m .
Conditional expectations
Before we continue this lecture, we need to introduce the concept of conditional
expectations (see also p.106-107 in Hult & Lindskog)
Let L
2
denote the space of all random variables X such that E
_
X
2
<
Let Z be a random variable and let L
2
(Z) L
2
denote the space of all
random variables Y such that Y = g(Z) for some function g and Y L
2
Note that E[X] is the value that minimizes the quantity E
_
(X )
2
.
Inspired by this, we dene the conditional expectation E[ X | Z] as follows:
Denition of conditional expectations
For a random variable Z, and for X L
2
, the conditional expectation E[ X | Z] is
the random variable Y L
2
(Z) that minimizes E
_
(X Y)
2
.
Intuitively, we can think of E[ X | Z] as the orthogonal projection of X onto
the space L
2
(Z), where the scalar product X, Y is dened as
X, Y = E[XY].
Properties of conditional expectations
For a random variable Z it is possible to show the following properties (see
p.106-107 in Hult& Lindskog)
1. If X L
2
, then E[E[ X | Z]] = E[X]
2. If Y L
2
(Z), then E[ YX | Z] = YE[ X | Z]
3. If X L
2
, we dene Var(X|Z) as
Var(X|Z) = E
_
X
2
E[ X | Z]
2
and it holds that Var(X) = E[Var(X|Z)] + Var (E[ X | Z]).
Furthermore, for an event A, we can dene the conditional probability P[ A| Z] as
P[ A| Z] = E[ 1
A
| Z]
where 1
A
is the indicator function for the event A (note that 1
A
is a random
variable). An example: if X {a, b}, let A = {X = a}, and we get that
P[ X = a | Z] = E
_
1
{X=a}
.
The binomial model is also the starting point for more sophisticated models.
For example, the mixed binomial model which randomizes the default
probability in the standard binomial model, allowing for stronger dependence.
The economic intuition behind this randomizing of the default probability
p(Z) is that Z should represent some common background variable aecting
all obligors in the portfolio.
The mixed binomial distribution works as follows: Let Z be a random
variable on R with density f
Z
(z) and let p(Z) [0, 1] be a random variable
with distribution F(x) and mean p, that is
F(x) = P[p(Z) x] and E[p(Z)] =
_

p(z)f
Z
(z)dz = p. (3)
Let X
1
, X
2
, . . . X
m
be identically distributed random variables such that
X
i
= 1 if obligor i defaults before time T and X
i
= 0 otherwise.
Furthermore, conditional on Z, the random variables X
1
, X
2
, . . . X
m
are
independent and each X
i
have default probability p(Z), that is
P[ X
i
= 1 | Z] = p(Z)
Since P[ X
i
= 1 | Z] = p(Z) we get that E[ X
i
| Z] = p(Z), because
E[ X
i
| Z] = 1 P[ X
i
= 1 | Z] + 0 (1 P[ X
i
= 1 | Z]) = p(Z). Furthermore,
note that E[X
i
] = p and thus p = E[p(Z)] = P[X
i
= 1] since
P[X
i
= 1] = E[X
i
] = E[E[ X
i
| Z]] = E[p(Z)] =
_
1
0
p(z)f
Z
(z)dz = p.
where the last equality is due to (3).
One can show that (see p.88 in Hult& Lindskog)
Var(X
i
) = p(1 p) and Cov(X
i
, X
j
) = E
_
p(Z)
2
p
2
= Var(p(Z)) (4)
Next, letting all losses be the same and constant given by, say , then the
total credit loss in the portfolio at time T, called

L
m
, is
L
m
=
m
i =1
X
i
=
m
i =1
X
i
= N
m
where N
m
=
m
i =1
X
i
thus, N
m
is the number of defaults in the portfolio up to time T
Again, since P
_
L
m
= k
_
= P[N
m
= k], it is enough to study N
m
.
The mixed binomial model, cont.
However, since the random variables X
1
, X
2
, . . . X
m
now only are
conditionally independent, given the outcome Z, we have
P[ N
m
= k | Z] =
_
m
k
_
p(Z)
k
(1 p(Z))
mk
so since P[N
m
= k] = E[P[ N
m
= k | Z]] = E
__
m
k
_
p(Z)
k
(1 p(Z))
k
it
holds that
P[N
m
= k] =
_

_
m
k
_
p(z)
k
(1 p(z))
mk
f
Z
(z)dz. (5)
Furthermore, since X
1
, X
2
, . . . X
m
no longer are independent we have that
Var(N
m
) = Var
_
m
i =1
X
i
_
=
m
i =1
Var(X
i
) +
m
i =1
m
j=1,j=i
Cov(X
i
, X
j
) (6)
and by homogeneity in the model we thus get
Var(N
m
) = mVar(X
i
) + m(m 1)Cov(X
i
, X
j
). (7)
So inserting (4) in (7) we get that
Var(N
m
) = m p(1 p) + m(m 1)
_
E
_
p(Z)
2
p
2
_
. (8)
Next, it is of interest to study how our portfolio will behave when m ,
that is when the number of obligors in the portfolio goes to innity.
Recall that Var(aX) = a
2
Var(X) so this and (8) imply that
Var
_
N
m
m
_
=
Var(N
m
)
m
2
=
p(1 p)
m
+
(m 1)
_
E
_
p(Z)
2
p
2
_
m
.
We therefore conclude that
Var
_
N
m
m
_
E
_
p(Z)
2
p
2
as m (9)
Note especially the case when p(Z) is a constant, say p, so that p = p.
Then we are back in the standard binomial loss model and
E
_
p(Z)
2
p
2
= p
2
p
2
= 0 so Var
_
N
m
m
_
0, i.e. the average number of
defaults in the portfolio converge to a constant (which is p) as the portfolio
size tend to innity (this is the law of large numbers.)
So in the mixed binomial model, we see from (9) that the law of large
numbers do not hold, i.e. Var
_
N
m
m
_
does not converge to 0.
Consequently, the average number of defaults in the portfolio, i.e.
N
m
m
, does
not converge to a constant as m .
This is due to the fact that the random variables X
1
, X
2
, . . . X
m
, are not
independent. The dependence among the X
1
, X
2
, . . . X
m
, is created by Z.
However, conditionally on Z, we have that the law of large numbers hold
(because if we condition on Z, then X
1
, X
2
, . . . X
m
are i.i.d with default
probability p(Z)), that is (see also p. 89 in Hult & Lindskog)
given a xed outcome of Z then
N
m
m
p(Z) as m (10)
and since a.s convergence implies convergence in distribution (see also p.
105 in Hult & Lindskog) then (10) implies that for any x [0, 1] we have
P
_
N
m
m
x
_
P[p(Z) x] when m . (11)
Note that (11) can also be veried intuitive from (10) by making the
following observation. From (10) we have that
P
_
N
m
m

Z
_
_
0 if p(Z) >
1 if p(Z)
as m
that is,
P
_
N
m
m

Z
_
1
{p(Z)}
as . (12)
Next, recall that
P
_
N
m
m

_
= E
_
P
_
N
m
m

Z
__
(13)
so (12) in (13) renders
P
_
N
m
m

_
E
_
1
{p(Z)}
= P[p(Z) ] = F() as m
where F(x) = P[p(Z) x], i.e. F(x) is the distribution function of the
random variable p(Z).
Large Portfolio Approximation (LPA)
Hence, from the above remarks we conclude the following important result:
Large Portfolio Approximation (LPA) for mixed binomial models
For large portfolios in a mixed binomial model, the distribution of the average
number of defaults in the portfolio converges to the distribution of the random
variable p(Z) as m , that is for any x [0, 1] we have
P
_
N
m
m
x
_
P[p(Z) x] when m . (14)
The distribution P[p(Z) x] is called the Large Portfolio Approximation (LPA) to
the distribution of
N
m
m
.
The above result implies that if p(Z) has heavy tails, then the random variable
N
m
m
will also have heavy tails, as m , which then implies a strong default
dependence in the credit portfolio.
The mixed binomial model: the beta function
One example of a mixing binomial model is to let p(Z) = Z where Z is a
beta distribution, Z Beta(a, b), which can generate heavy tails.
We say that a random variable Z has beta distribution, Z Beta(a, b), with
parameters a and b, if its density f
Z
(z) is given by
f
Z
(z) =
1
(a, b)
z
a1
(1 z)
b1
a, b > 0, 0 < z < 1 (15)
where (a, b) denotes the beta function which satises the recursive relation
(a + 1, b) =
a
a + b
(a, b).
Also note that (15) implies that P[0 Z 1] = 1, that is Z [0, 1] with
probability one.
Furthermore, since p(Z) = Z, the distribution of
N
m
m
converges to the
distribution of the beta distribution, i.e
P
_
N
m
m
x
_
1
(a, b)
_
x
0
z
a1
(1 z)
b1
dz as m
The mixed binomial model: the beta function, cont.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
0
2
4
6
8
10
12
14
x
d
e
n
s
i
t
y
Two different beta densities

a=1,b=9
a=10,b=90
If Z has beta distribution with parameters a and b, one can show that
E[Z] =
a
a + b
and Var(Z) =
ab
(a + b)
2
(a + b + 1)
.
Consider a mixed binomial model where p(Z) = Z has beta distribution with
parameters a and b. Then, by using (5) one can show that
P[N
m
= k] =
_
m
k
_
(a + k, b + m k)
(a, b)
. (16)
It is possible to create heavy tails in the distribution P[N
m
= k] by
choosing the parameters a and b properly in (16). This will then imply more
realistic probabilities for extreme loss scenarios, compared with the standard
binomial loss distribution (see gure on next page).
0 5 10 15 20 25 30
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
number of defaults
p
r
o
b
a
b
i
l
i
t
y
The portfolio credit loss distribution in the standar and mixed binomial model

mixed binomial 50, beta(1,9)
binomial(50,0.1)
Mixed binomial models: logit-normal distribution
Another possibility for mixing distribution p(Z) is to let p(Z) be a
logit-normal distribution. This means that
p(Z) =
1
1 + exp (( + Z))
where > 0 and Z N(0, 1), that is Z is a standard normal random
variable. Note that p(Z) [0, 1].
Furthermore, if 0 < x < 1 then p
1
(x) is well dened and given by
p
1
(x) =
1
_
ln
_
x
1 x
_
_
. (17)
The mixing distribution F(x) = P[p(Z) x] = P
_
Z p
1
(x)
for a
logit-normal distribution is then given by
F(x) = P
_
Z p
1
(x)
= N(p
1
(x)) for 0 < x < 1
where p
1
(x) is given as in Equation (17) and N(x) is the distribution
function of a standard normal distribution.
Correlations in mixed binomial models
Recall the denition of the correlation Corr (X, Y) between two random
variables X and Y, given by
Corr (X, Y) =
Cov (X, Y)
_
Var (X)
_
Var (Y)
where Cov(X, Y) = E[XY] E[X] E[Y] and Var (X)) = E
_
X
2
E[X]
2
.
Furthermore, also recall that Corr (X, Y) may sometimes be seen as a
measure of the dependence between the two random variables X and Y.
Now, let us consider a mixed binomial model as presented previously.
We are interested in nding Corr (X
i
, X
j
) for two pairs i , j in the portfolio
(by the homogeneous-portfolio assumption this quantity is the same for any
pair i , j in the portfolio where i = j ).
Below, we will therefore for notational convenience simply write
X
for the
correlation Corr (X
i
, X
j
).
Correlations in mixed binomial models, cont.
Recall from previous slides that P[ X
i
= 1 | Z] = p(Z) where p(Z) is the
mixing variable.
Furthermore, from p.88 in Hult & Lindskog we also now that
Cov(X
i
, X
j
) = E
_
p(Z)
2
p
2
and Var(X
i
) = p(1 p) (18)
where p = E[p(Z)].
Thus, the correlation
X
in a mixed binomial models is then given by
X
=
E
_
p(Z)
2
p
2
p(1 p)
(19)
where p = E[p(Z)] = P[X
i
= 1] is the default probability for each obligor.
Hence, the correlation
X
in a mixed binomial is completely determined by
the st two moments of the mixing variable p(Z), that is E[p(Z)] and
E
_
p(Z)
2
.
Exercise 1: Show that P[X
i
= 1, X
j
= 1] = E
_
p(Z)
2
where i = j .
Exercise 2: Show that Var(X
i
) = E[p(Z)] (1 E[p(Z)]).
Value-at-Risk
Recall the denition of Value-at-Risk (see e.g. p.14 in Hult & Lindskog)
Denition of Value-at-Risk
Given a loss L and a condence level (0, 1), then VaR
(L) is given by the

smallest number y such that the probability that the loss L exceeds y is no larger
than 1 , that is
VaR
(L) = inf {y R : P[L > y] 1 }

= inf {y R : 1 P[L y] 1 }
= inf {y R : F
L
(y) }
where F
L
(x) is the distribution of L.
Note that Value-at-Risk is dened for a xed time horizon, so the above
denition should also come with a time period, e.g, if the loss L is over one
day, then we talk about a one-day VaR
(L).
In credit risk, one typically consider VaR
(L) for the loss over one year.

Note that if F
L
(x) is continuous, then VaR
(L) = F
1
L
()
Value-at-Risk for static credit portfolios
Consider the same type of homogeneous static credit portfolio models as
studied previously today, with m obligors and where each obligor can default
up to time T. Each obligor have identical credit loss at a default, where
is a constant.
The total credit loss in the portfolio at time T is then given by L
m
= N
m
where N
m
is the number of defaults in the portfolio up to time T.
Note that the individual loss is given by

N where N is the notional of the
individual loan and

is the loss as a fraction of N (i.e

[0, 1])
By linearity of VaR (see in lecture notes by H&L) we can without loss of
generality assume that N = 1, so that

= , since
VaR
(cL) = cVaR
(L)
Value-at-Risk for static credit portfolios, cont.
If p(Z) is a mixing variable with distribution F(x) we know that
P
_
N
m
m
x
_
F(x) as m
which implies that
P[L
m
x] = P
_
N
m
m

x
m
_
F
_
x
m
_
as m
Hence, if F(x) is continuous, and if m is large, we have the following
approximation formula for VaR
(L)
VaR
(L) m F
1
() (20)
where L denotes the loss L
m
.
Expected shortfall
The expected shortfall ES
(L) is dened as
ES
(L) = E[ L | L VaR
(L)]
and one can show that (see e.g p.19 in Hult & Lindskog)
ES
(L) =
1
1
_
1
VaR
u
(L)du.
Hence, for the same static credit portfolio as on the two previous slides, we have
the following approximation formula for ES
(L) (when m is large)

ES
(L)
m
1
_
1
F
1
(u)du
where L denotes the loss L
m
and where we used (20). Here, F(x) is the
continuous distribution of the mixing variable p(Z).
Thank you for your attention!

Financial Risk: Credit Risk, Lecture 1: Alexander Herbertsson

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Financial Risk: Credit Risk, Lecture 1: Alexander Herbertsson

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What are the main components of credit risk?

What are the different static portfolio credit risk models discussed?

Financial Risk: Credit Risk, Lecture 1

0 as m . Note that this

(L) is given by the

(L) = inf {y R : P[L > y] 1 }

(L) for the loss over one year.

(L) (when m is large)

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