Abstract

Journal of Actuarial Practice

Volume 13, 2006

Consistent Assumptions for Modeling Credit Loss Correlations

Jan Dhaene, Marc Goovaerts, Robert Koch, Ruben Olieslagers, Olivier Romijn, and Steven Vanduffel

Abstract

We consider a single period portfolio of n dependent credit risks that are subject to default during the period. We show that using stochastic loss given default random variables in conjunction with default correlations can give rise to an inconsistent set of assumptions for estimating the variance of the portfolio loss. Two sets of consistent assumptions are provided, which it turns out, also provide bounds on the variance of the portfolio's loss. An example of an inconsistent set of assumptions is given.

Key words and phrases: default correlation, loss correlation, comonotonicity, economic capital

Corresponding Author:

Steven Vanduffel

Katholieke Univzrsiteit Leuven

Department of Applied Economics,

University Leuven

Naamsestraat 69,

B-3000, Leuven

BELGIUM.

E-mail: Steven.vanduffel@econ.kuleuven.ac.be