Integrating Interest Rate Risk in Credit Portfolio Models

Abstract

I. INTRODUCTION A typical shortcoming of most current credit portfolio models is the lack of a stochastic modeling of risk factors, such as interest rates or credit spreads, during the revaluation process at the risk horizon. For example, fixed income instruments, such as bonds or loans, are revalued at the risk horizon using the current forward rates and (rating class specific) forward credit spreads for discounting future cash flows. Hence, the stochastic nature of the instrument's value in the future which results from changes in factors other than credit quality is ignored, and the riskiness of the credit portfolio at the risk horizon is underestimated. A further consequence is that correlations between changes of the debtor's default probability and changes of market risk factors and, hence, the exposure at default cannot be integrated into the credit portfolio model. This drawback is especially relevant for portfolios of defaultable market‐driven derivatives. One reason why risk factors not directly related to credit risk are neglected in most current credit portfolio models is that there is still no commonly accepted approach for modeling the credit quality of a debtor and the dependencies between the credit quality changes of different debtors. Hence, it might be over‐ambitious to incorporate correlations between market risk factors and credit quality changes. Even empirical evidence on the sign of the correlation remains inconclusive. Additionally, introducing stochastic market risk factors and modeling the correlation between these risk factors and credit quality changes would significantly increase the computational burden for calculating robust risk measures of credit portfolios.

Citation

GRUNDKE, P. (2004), "Integrating Interest Rate Risk in Credit Portfolio Models", Journal of Risk Finance, Vol. 5 No. 2, pp. 6-15. https://doi.org/10.1108/eb022982