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Incorporating Severity Variations into Credit Risk
Citation key BKW-2004-Incorporating-Severity-Variations-into-Credit-Risk
Author Peter Bürgisser and Alexandre Kurth and Armin Wagner
Title of Book Innovations in Risk Management
Pages 533-567
Year 2004
Editor P. Jorion
Publisher Incisive Media Investments Limited
Series Seminal Papers from the Journal of Risk
Abstract We present an approach to model credit risk that incorporates the risk of counterparty default and the risk of devaluation of the collateral. The framework is based on a two-dimensional segmentation by industry and collateral type. The systematic effects in both risk drivers are taken into account by volatilities within, and by correlations between the segments. We derive a simple formula for the variance of the loss distribution and describe an algorithm to compute this distribution. Moreover, we show that in the limit of a large portfolio, the loss distribution directly mirrors the assumptions on the economy and depends on the portfolio structure only through the relative expected loss weights.
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