Incorporating Default Correlations and Severity Variations

Summary

The original CreditRisk⁺ methodology does not allow for incorporation of industry, geographical or other segment correlations in modelling default events. We provide an extension that enables modelling of default correlations among segments while preserving the analytical solution for the loss distribution. Moreover, the proposed methodology can consistently be extended to independently (of default events) model stochastic severities in collateral devaluation. This extension imposes further distributional assumptions on the model. Nevertheless, it is shown that in the limit of a large portfolio the loss distribution is determined solely by the systematic components of default and severity risk. Finally, the relevance of this observation to portfolio management and stress loss analysis is motivated.