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Specification Risk and Calibration Effects of a Multifactor Credit Portfolio Model

Gregor Dorfleitner, Matthias Fischer and Marco Geidosch
The Journal of Fixed Income Summer 2012, 22 (1) 7-24; DOI: https://doi.org/10.3905/jfi.2012.22.1.007
Gregor Dorfleitner
is a professor of finance at the University of Regensburg in Regensburg, Germany.
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  • For correspondence: gregor.dorfleitner@wiwi.uni-regensburg.de
Matthias Fischer
is an assistant professor of statistics and econometrics at the University of Erlangen-Nürnberg in Nürnberg, Germany.
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  • For correspondence: matthias.fischer@wiso.uni-erlangen.de
Marco Geidosch
is a Ph.D. student at the University of Regensburg in Regensburg, Germany.
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  • For correspondence: marco.geidosch@wiwi.uni-regensburg.de
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Abstract

This article examines a crucial source of specification risk when calibrating a typical industry-type, Merton-based credit portfolio model. It emerges from the necessity of having to choose a proxy for creditworthiness. In addition to equity prices and asset values, which are the classical choices, the authors consider credit default swap (CDS) spreads and expected default frequencies (EDF, from Moody’s KMV) as alternatives. Based on 40 large European companies from different industries, the authors calibrate a macroeconomic factor model with an OLS regression analysis for each specification and calculate the corresponding economic capital. Eighteen macroeconomic and financial variables are considered as risk factors. Their findings are: a) on average, two to three risk factors are needed to adequately model creditworthiness on the obligor level, b) stock market variables are the most important risk factors, c) model-implied credit correlation is extremely sensitive to the choice of the proxy for creditworthiness, and d) only the EDF specification leads to less economic capital compared with regulatory capital, according to Basel II, while it is exceeded substantially by all other specifications. In particular, credit correlation in the CDS specification by far exceeds any estimate mentioned in the literature. Most important, the authors show that the economic capital of their sample portfolio can be reduced by 78%, depending on which variable is chosen as a proxy for creditworthiness.

TOPICS: Factor-based models, credit default swaps, credit risk management, simulations

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The Journal of Fixed Income: 22 (1)
The Journal of Fixed Income
Vol. 22, Issue 1
Summer 2012
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Specification Risk and Calibration Effects of a Multifactor Credit Portfolio Model
Gregor Dorfleitner, Matthias Fischer, Marco Geidosch
The Journal of Fixed Income Jun 2012, 22 (1) 7-24; DOI: 10.3905/jfi.2012.22.1.007

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Specification Risk and Calibration Effects of a Multifactor Credit Portfolio Model
Gregor Dorfleitner, Matthias Fischer, Marco Geidosch
The Journal of Fixed Income Jun 2012, 22 (1) 7-24; DOI: 10.3905/jfi.2012.22.1.007
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  • Article
    • Abstract
    • CREDIT PORTFOLIO RISK MODEL
    • PROXIES FOR CREDITWORTHINESS
    • CALIBRATION FRAMEWORK
    • DATA
    • RESULTS
    • SUMMARY AND CONCLUSION
    • APPENDIX A
    • APPENDIX B
    • APPENDIX C
    • ENDNOTES
    • REFERENCES
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