IEOR E4731: Credit Risk and Credit Derivatives

Lecture 13: A General Picture of Portfolio Credit Risk Modeling

Instructor: Xuedong He
Spring, 2013
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Portfolio Credit Risk Modeling

There are two main approaches of portfolio credit risk

modeling

Bottom-up approach: model the default risk of each obligor

in the portfolio and build the portfolio loss by specifying
certain correlation structure among dierent obligors.

Structural models

Reduced-form models

Copula models

Intensity-based models

Top-down approach: model the portfolio loss directly

without modeling the default risk for individual obligors.
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Bottom-up Approach

With a few exceptions, structural models in portfolio credit

risk modeling are not available in the literature. Even for
those exceptions, the assumptions made therein are too
restrictive to be realistic. See for instance, [Zhou, 2001] and
[Bush et al., 2011].

Copula models are simple and popular in industry. However,

they are static models and the denition of correlation
through latent variables has no economic interpretation. In
addition, the hedging practice based on copula models does
not work well.

Intensity-based models have been developed in recent years

and have potential for the practical use of portfolio credit risk
assessment and multi-name credit derivative pricing.
3 / 23
Default Times in Doubly Stochastic Intensity-based Models

Recall that the default time,

i
, of each obligor i is modeled
as the rst jump time of a doubly stochastic process, i.e.,

i
:= inf{t 0 |
_
t
0

i
(u)du > E
i
}
where
i
() is the intensity process adapted to the market
information {F
t
}
t
0 and E
i
is a unit exponential random
variable that is unobservable and independent of the market
information.

At each time t,
i
(t), the probability of obligor i default next
per unit time, is observable. The default time, however, is
unpredictable.

Key assumption: E
i
s are independent among dierent
obligors. As a result, given the intensities
i
s, the default
times are independent of each other.

The default correlation only lies in the correlation among

the intensities.
4 / 23
How to Model Intensities?

In doubly stochastic models, the intensities

i
s should be
observable.

Therefore, each
i
should depend on some observable
variables in the market.

We can model
i
(t) =
i
(U
i
(t), V (t)) for some function
i
,
where U
i
() is the dynamics of a vector of rm-specic
variables and V () is the dynamics of a vector of market-wide
variables.

Examples of U
i
: rms distance-to-default, rms size, rms
trailing one-year stock return. Examples of V (): the
three-month Treasury bill rate, the ten-year Treasury yield,
the trailing one-year return on S&P 500 index.

Which variables are relevant?

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How to Model Intensities? (Contd)

[Due et al., 2007] studied the eect of a set of rm-specic

variables and market-wide variables on the default intensities
under objective probability measure. The authors found that
the rms distance-to-default, the rms trailing one-year
stock return, and the three-month Treasury bill rate have
negative eect on the default intensities, and the trailing
one-year return on S&P 500 index has positive impact.

In the presence of these four variables, other variables have

little eect

If we assess portfolio loss, we should employ the objective

probability measure.

If we deal with pricing problems, we should employ

risk-neutral probability measure. The results under the
objective probability measure still shed some light on the
dependence of the default intensities on the market observable
variables under risk-neutral probability measure.
6 / 23
Computing Portfolio Loss Distribution

We consider a special case of doubly stochastic models, in

which we could compute the portfolio loss distribution
semi-analytically.

For the purpose of portfolio risk assessment, we should use

objective probability measure. For the purpose of derivative
pricing, we should use risk-neutral probability measure.

The total loss of a portfolio consisting of obligors

i = 1, . . . , M up to time t is
L(t) :=
M

i=1
N
i
(1 R
i
)1
{t}
.

If we assume both N
i
s and R
i
s are constant among obligors,
the total loss becomes L(t) = N(1 R)n(t), where
n(t) :=

M
i=1
1
{t}
is the number of default up to time t.
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Computing Portfolio Loss Distribution (Contd)

Assume
i
(t) = a
i

m
(t) +
id
i
(t), where
m
is the common
factor,
id
i
is the idiosyncratic factor, and a
i
is some constant.
Assume
m
,
id
i
s are independent.

For instance,
m
(t) =
m
(V (t)) for some function
m
,

id
i
(t) =
id
i
(U
i
(t)) for some function
id
i
, and V () and U
i
()
are independent.

Suppose the current time is 0 and we want to compute the

probability of n(t) = j.

Key observation: conditioning on the common factor

m
,
the default times
i
s are independent of each other.

Apply the recursive algorithm to compute the probability of

n(t) = j.
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Computing Portfolio Loss Distribution (Contd)

We rst compute the probability of

i
> t conditioning on
m
.
Q(
i
> t |
m
(u), u 0)
=E
Q
_
Q
_

i
> t |
id
(u),
m
(u), u 0
_
|
m
(u), u 0
_
=E
Q
_
e

t
0
(a
i

m
(u)+
id
i
(u))du
|
m
(u), u 0
_
=e
a
i

m
(t)
E
Q
_
e

id
(t)
_
,
where
m
(t) :=
_
t
0

m
(u)du and
id
(t) :=
_
t
0

id
(u)du are
cumulative intensity processes.

For xed time t, the conditional probability is a function of

Z :=
m
(t).
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Computing Portfolio Loss Distribution (Contd)

Denote by q
c
i
(t, z) the survival probability of
i
> t
conditioning on Z = z, i.e.,
q
c
i
(t, z) := e
a
i
z
E
Q
_
e

id
(t)
_
.

The probability of n(t) = j conditioning on

m
, or Z = z, can
be computed by the same recursive algorithm in the Gaussian
latent variable model.

The doubly stochastic model and the recursive algorithm were

proposed by [Due and Garleanu, 2001] and
[Mortensen, 2006].

In order to obtain semi-analytical formula, we need to know

(i) the distribution of Z; and (ii) how to compute q
c
i
(t, z).
10 / 23
Computing Portfolio Loss Distribution (Contd)

Suppose
m
(t) is an ane function of V (t), i.e.,

m
(t) =
0
+
1
V (t).

If V (t) is an O-U process:

dV (t) = (V (t) )dt +dW(t),
then
_
t
0
V (u)du is a normal random variable, and so is Z.

More generally, if V () is an ane process, then the Laplace

transform and Fourier transform of
_
t
0
V (u)du can be
computed explicitly. As a result, the distribution of Z can be
obtained easily.
11 / 23
Ane Processes

A stochastic process X is an ane process if it satises

dX(t) = (X(t))dt +(X(t))dW(t) +dJ(t)
where W() is a Brownian motion, J() is a pure jump process
with intensity (X(t)) and is independent of W(), and (x),
(x)
2
, and (x) are ane functions. See for instance,
[Due et al., 2000].

Examples of ane processes:

O-U processes

CIR processes
dX(t) = (b X(t))dt +
_
X(t)dW(t)
12 / 23
Conditional and Unconditional Survival Probabilities

On the other hand, if

id
i
(t) is an ane process, E
Q
_
e

id
(t)
_
has explicit formula. As a result, we can obtain q
c
i
(t, z).

The survival probability of obligor i is

q
i
(t) :=Q(
i
> t) = E[q
c
i
(t, Z)]
=E
Q
_
e
a
i
Z

E
Q
_
e

id
(t)
_
.

Therefore,
q
c
i
(t, z) =
e
a
i
z
E
Q
[e
a
i
Z
]
q
i
(t).
This equality holds once
id
i
and
m
are independent. No
further assumption on
id
i
and
m
is needed.
13 / 23
Conditional and Unconditional Survival Probabilities
(Contd)

If we are evaluating probabilities under the risk-neutral

probability measure for the purpose of pricing, q
i
(t) can be
calibrated from single-name CDS spread curve for obligor i.

In this case, in order to compute the portfolio loss

distribution, we only need to know the distribution of Z.

See for instance, [Eckner, 2009] for how to use doubly

stochastic models to price multi-name credit derivatives.
14 / 23
Test of Doubly Stochastic Models

[Das et al., 2007] found that doubly stochastic models fail to

account for the historical default clustering. In other words,
the correlation among the intensities are not sucient to
explain the historical default clustering.

As a result, doubly stochastic models may not be able to price

multi-name credit derivatives, especially senior tranches well.

Possible solutions:

Add unobservable variables, called frailty, in intensities

Include common jumps in cumulative intensities

Add correlation in the exponential barrier

Contagion eect: the default of one rm may increase the

default intensities of other rms.
15 / 23
Models with Frailty

[Due et al., 2009] considered the so-called frailty correlated

model, an intensity-based model with unobservable variables,
i.e., the default intensity of obligor i is

i
(t) =
i
(U
i
(t), V (t), Y
i
(t), Y (t)), where Y
i
is the vector of
rm-specic unobservable variables and Y is the vector of
market-wide unobservable variables. Those unobservable
variables are called frailty.

[Due et al., 2009] found strong evidence for the presence of

market-wide unobservable variables.

It seems that adding correlation in the exponential barrier is

a special case of adding unobservable variables in intensities.

No work on how to apply frailty correlated model to price

multi-name credit derivatives
16 / 23
Modeling Cumulative Intensities

[Kou and Peng, 2012] modeled the cumulative intensities

instead of the intensities:

i
(t) = a
i

m
(t) +
id
i
(t)
where
m
is the market factor and
id
i
s are idiosyncratic
factors.

The market factor

m
can have jump, which may cause
multiple defaults at a same time.

[Kou and Peng, 2012] applied this model to price STCDOs.

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Modeling Contagion

Neither frailty correlated models nor cumulative intensity

models consider the contagion eect

There are some works on contagion eect, but all are not rich
enough to price multi-name credit derivatives
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Top-down Models

In top-down models, the portfolio loss or the number of

defaults is modeled as a stochastic process.

Local intensity model: the number of defaults n(t) is a

Markov point process with intensity
t
= f(t, n(t)). As a
consequence, the intensity is constant between two default
times. For this model, see for instance,
[Cont and Minca, 2012].

Local intensity models cannot generate CDO spread volatility

between default dates.

Bivariate intensity model: the number of defaults n(t) is a

Markov point process with intensity
t
= f(t, n(t 1), Y (t)),
where Y (t) is an additional source of risk. For instance, Y (t)
may follows the following O-U process
dY (t) = Y (t)dt +dW(t).
See for instance, [Arnsdorf and Halperin, 2008].
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Top-down Models (Contd)

In both local intensity models and bivariate intensity models,

Q(n(t + t) = i + 1 | n(t) = i) =
t
t +o(t),
Q(n(t + t) = i +k | n(t) = i) = o(t), k > 1.
As a result, in those models, the probability of multiple
defaults in a short time period is negligible.

In order to capture the historical default clustering, one need

to explore beyond those two models. For example, one may
consider a model in which
Q(n(t + t) = j | n(t) = i) =
_

_
f
ij
(t)t +o(t), j > i,
1
i
(t)t +o(t), j = i,
0, j < i,
where
i
(t) :=

N
j=i+1
f
ij
(t) is the total jump intensity. This
model is actually a continuous-time Markov chain. See for
instance, [Schonbucher, 2005].
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Comparison of Bottom-up and Top-down Models

Bottom-up models specify the default structure of each

obligor. They could be calibrated to default probabilities or
CDS spread curves of individual obligors. After calibration,
these models can be used to asset the risk of any credit
portfolio or price any multi-name credit derivatives.

For top-down models, the portfolio loss is specic to the

underlying portfolio. Thus, after you calibrate a model, it can
only be used for that particular portfolio. Top-down models,
however, are simpler than bottom-up models.
21 / 23
Hedging Practice for CDOs

The common practice of hedging for CDOs is to perform

sensitivity analysis
1. Identify the risk factors
2. Compute the sensitivity w.r.t. the risk factors
3. Compute the hedging strategy.

For example, the risk factors in a Copula model might include

the spreads of individual obligors and the correlation among
the latent variables

For example, the risk factors in a bottom-up model might

include the spreads of individual obligors and some
market-wide variables

Two types of spread risk:

Systemic spread risk: all credit spread curves change by a same

amount. In this case, CDX in a good hedging instrument.

Idiosyncratic risk: one of the credit spread change by some

amount while others keep unchanged. In this case, individual
CDS contracts are needed to hedge the risk.

In practice, spreads movement exhibits a mixture of systemic

and idiosyncratic moves
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Poor Performance of Some Existing Hedging Practice for
CDOs

[Cont and Kan, 2011] investigated the performance of several

possible hedging methods:

Hedging against systemic spread risk, idiosyncratic spread risk,

and correlation risk in Gaussian copula models.

Hedging against systemic spread risk, idiosyncratic spread risk

in doubly stochastic models

A hedging method in local intensity models

A hedging method in bivariate intensity models

All these methods perform poorly

Open problems:

Can we improve the hedging performance in doubly stochastic

models by hedging against market-wide variables?

Can we improve the hedging performance by including

nonobservable variables as in [Due et al., 2009] or by
considering cumulative intensities with jumps as in
[Kou and Peng, 2012]?
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Arnsdorf, M. and Halperin, I. (2008).
Markovian bivariate spread-loss model for portfolio credit
derivatives.
Journal of Computational Finance, 12:77107.
Bush, N., Hambly, B. M., Haworth, H., Jin, L., and Reisinger,
C. (2011).
Stochastic evolution equations in portfolio credit modelling.
SIAM Journal of Financial Mathematics, 2:627664.
Cont, R. and Kan, Y. H. (2011).
Dynamic hedging of portfolio credit derivatives.
SIAM Journal of Financial Mathematics, 2(1):112140.
Cont, R. and Minca, A. (2012).
Recovering portfolio default intensities implied by CDO quotes.
Mathematical Finance.
Das, S. R., Due, D., Kapadia, N., and Saita, L. (2007).
Common failings: How corporate defaults are correlated.
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Journal of Finance, 62(1):93117.
Due, D., Eckner, A., Horel, G., and Saita, L. (2009).
Frailty correlated default.
Journal of Finance, 64(5):20892123.
Due, D. and Garleanu, N. (2001).
Risk and valuation of collateralized debt obligations.
Financial Analysts Journal, 57(1):4159.
Due, D., Pan, J., and Singleton, K. (2000).
Transform analysis and asset pricing for ane jump-diusions.
Econometrica, 68(6):13431376.
Due, D., Saita, L., and Wang, K. (2007).
Multi-period corporate default prediction with stochastic
covariates.
Journal of Financial Economics, 83(3):635665.
Eckner, A. (2009).
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Computational techniques for basic ane models of portfolio
credit risk.
Journal of Computational Finance, 13:6397.
Kou, S. G. and Peng, X. H. (2012).
Default clustering and valuation of collateralized debt
obligations.
Working Paper.
Mortensen, A. (2006).
Semi-analytical valuation of basket credit derivatives in
intensity-based models.
Journal of Derivatives, 13(4):826.
Schonbucher, P. J. (2005).
Portfolio losses and the term structure of loss transition rates:
a new methodology for the pricing of portfolio credit
derivatives.
Unpublished manuscript.
Zhou, C. (2001).
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An analysis of default correlations and multiple defaults.
Review of Financial Studies, 14(2):555576.
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