Granularity Adjustment for Risk Measures: Systematic vs Unsystematic Risks

Similar documents
GRANULARITY ADJUSTMENT FOR DYNAMIC MULTIPLE FACTOR MODELS : SYSTEMATIC VS UNSYSTEMATIC RISKS

Dependence Modeling and Credit Risk

2 Modeling Credit Risk

Pricing Default Events: Surprise, Exogeneity and Contagion

Asymptotic Risk Factor Model with Volatility Factors

Firm Heterogeneity and Credit Risk Diversification

A simple model to account for diversification in credit risk. Application to a bank s portfolio model.

Analytical Pricing of CDOs in a Multi-factor Setting. Setting by a Moment Matching Approach

Credit VaR and Risk-Bucket Capital Rules: A Reconciliation

The University of Chicago, Booth School of Business Business 41202, Spring Quarter 2012, Mr. Ruey S. Tsay. Solutions to Final Exam

Dependence Modeling and Credit Risk

The University of Chicago, Booth School of Business Business 41202, Spring Quarter 2009, Mr. Ruey S. Tsay. Solutions to Final Exam

Chapter 5 Univariate time-series analysis. () Chapter 5 Univariate time-series analysis 1 / 29

Efficient Concentration Risk Measurement in Credit Portfolios with Haar Wavelets

3.4 Copula approach for modeling default dependency. Two aspects of modeling the default times of several obligors

Granularity Theory with Applications to Finance and Insurance

TopQuants. Integration of Credit Risk and Interest Rate Risk in the Banking Book

IEOR E4602: Quantitative Risk Management

Introduction Credit risk

Stochastic Volatility (SV) Models

Risk Measurement in Credit Portfolio Models

Economi Capital. Tiziano Bellini. Università di Bologna. November 29, 2013

Dependence Structure and Extreme Comovements in International Equity and Bond Markets

High-Frequency Data Analysis and Market Microstructure [Tsay (2005), chapter 5]

A class of coherent risk measures based on one-sided moments

A Simple Multi-Factor Factor Adjustment for the Treatment of Diversification in Credit Capital Rules

Bilateral Exposures and Systemic Solvency Risk

Research Paper. Capital for Structured Products. Date:2004 Reference Number:4/2

STOCHASTIC CALCULUS AND BLACK-SCHOLES MODEL

Slides for Risk Management

Bonn Econ Discussion Papers

Practical example of an Economic Scenario Generator

Market risk measurement in practice

Credit VaR: Pillar II Adjustments

Advanced Tools for Risk Management and Asset Pricing

Statistical Methods in Financial Risk Management

A Simple Multi-Factor Factor Adjustment for the Treatment of Credit Capital Diversification

Math 416/516: Stochastic Simulation

Managing Systematic Mortality Risk in Life Annuities: An Application of Longevity Derivatives

Chapter 3: Black-Scholes Equation and Its Numerical Evaluation

ARCH and GARCH models

Basel II Second Pillar: an Analytical VaR with Contagion and Sectorial Risks

Online appendices from The xva Challenge by Jon Gregory. APPENDIX 8A: LHP approximation and IRB formula

Asset Allocation Model with Tail Risk Parity

Lecture notes on risk management, public policy, and the financial system Credit risk models

Survival of Hedge Funds : Frailty vs Contagion

Advanced Topics in Derivative Pricing Models. Topic 4 - Variance products and volatility derivatives

Unexpected Recovery Risk and LGD Discount Rate Determination #

1.1 Basic Financial Derivatives: Forward Contracts and Options

MTH6154 Financial Mathematics I Stochastic Interest Rates

Course information FN3142 Quantitative finance

The Vasicek Distribution

Characterization of the Optimum

Market interest-rate models

A No-Arbitrage Theorem for Uncertain Stock Model

Mathematics in Finance

Slides for Risk Management Credit Risk

The value of foresight

Calculating VaR. There are several approaches for calculating the Value at Risk figure. The most popular are the

The University of Chicago, Booth School of Business Business 41202, Spring Quarter 2011, Mr. Ruey S. Tsay. Solutions to Final Exam.

Price Impact, Funding Shock and Stock Ownership Structure

Two hours. To be supplied by the Examinations Office: Mathematical Formula Tables and Statistical Tables THE UNIVERSITY OF MANCHESTER

Portfolio Models and ABS

Financial Econometrics

CHOICE THEORY, UTILITY FUNCTIONS AND RISK AVERSION

The Black-Scholes Model

Financial Risk Management

Dynamic Replication of Non-Maturing Assets and Liabilities

such that P[L i where Y and the Z i ~ B(1, p), Negative binomial distribution 0.01 p = 0.3%, ρ = 10%

INTERTEMPORAL ASSET ALLOCATION: THEORY

Dynamic Relative Valuation

Credit Risk in Banking

Multi-period mean variance asset allocation: Is it bad to win the lottery?

A Unified Theory of Bond and Currency Markets

Discussion of The Term Structure of Growth-at-Risk

Systematic Risk in Homogeneous Credit Portfolios

Risk management. Introduction to the modeling of assets. Christian Groll

Introduction to Probability Theory and Stochastic Processes for Finance Lecture Notes

From Discrete Time to Continuous Time Modeling

AMH4 - ADVANCED OPTION PRICING. Contents

Calibrating Low-Default Portfolios, using the Cumulative Accuracy Profile

LECTURE NOTES 3 ARIEL M. VIALE

IMPA Commodities Course : Forward Price Models

A Multifrequency Theory of the Interest Rate Term Structure

Modeling dynamic diurnal patterns in high frequency financial data

Lecture Note 8 of Bus 41202, Spring 2017: Stochastic Diffusion Equation & Option Pricing

Luis Seco University of Toronto

Incorporating Managerial Cash-Flow Estimates and Risk Aversion to Value Real Options Projects. The Fields Institute for Mathematical Sciences

Int. Statistical Inst.: Proc. 58th World Statistical Congress, 2011, Dublin (Session CPS001) p approach

M.I.T Fall Practice Problems

BROWNIAN MOTION Antonella Basso, Martina Nardon

Concentration Risk. Where we are. Miguel A Iglesias Global Association of Risk Professionals. September 2014

The Minimal Confidence Levels of Basel Capital Regulation Alexander Zimper University of Pretoria Working Paper: January 2013

Equity correlations implied by index options: estimation and model uncertainty analysis

1. Covariance between two variables X and Y is denoted by Cov(X, Y) and defined by. Cov(X, Y ) = E(X E(X))(Y E(Y ))

Valuation of a New Class of Commodity-Linked Bonds with Partial Indexation Adjustments

Rough volatility models: When population processes become a new tool for trading and risk management

Are stylized facts irrelevant in option-pricing?

Financial Risk Forecasting Chapter 9 Extreme Value Theory

SOLVENCY AND CAPITAL ALLOCATION

Transcription:

Granularity Adjustment for Risk Measures: Systematic vs Unsystematic Risks Patrick Gagliardini Christian Gouriéroux October 200 Swiss Finance Institute and University of Lugano. CREST, CEPREMAP and University of Toronto. Acknowledgements: We thank A. Monfort and the participants at the Workshop on Granularity at AXA (Paris), the Finance Seminar of HEC Geneva and the SFI research workshop in Gerzensee for very useful comments. The first author gratefully acknowledges financial support of the Swiss National Science Foundation through the NCCR FINRISK network. The second author gratefully acknowledges financial support of NSERC Canada and the chair AXA/Risk Foundation: Large Risks in Insurance.

Granularity Adjustment for Risk Measures: Systematic vs Unsystematic Risks Abstract The granularity principle [Gordy (2003)] allows for closed form expressions of the risk measures of a large portfolio at order /n, where n is the portfolio size. The granularity principle yields a decomposition of such risk measures that highlights the different effects of systematic and unsystematic risks. This paper derives the granularity adjustment of the Value-at-Risk (VaR), the Expected Shortfall and the other distortion risk measures for both static and dynamic risk factor models. The systematic factor can be multidimensional. The methodology is illustrated by several examples, such as the stochastic drift and volatility model, or the dynamic factor model for joint analysis of default and loss given default. Keywords: Value-at-Risk, Granularity, Large Portfolio, Credit Risk, Systematic Risk, Loss Given Default, Basel 2 Regulation, Credibility Theory. JEL classification: G2, C23. 2

Introduction Risk measures such as the Value-at-Risk (VaR), the Expected Shortfall (also called Tail VaR) and more generally the Distortion Risk Measures (DRM) [Wang (2000)] are the basis of the new risk management policies and regulations in both Finance (Basel 2) and Insurance (Solvency 2). These measures are used to define the minimum capital required to hedge risky investments (Pillar in Basel 2). They are also used to monitor the risk by means of internal risk models (Pillar 2 in Basel 2). These risk measures have in particular to be computed for large portfolios of individual contracts, which can be loans, mortgages, life insurance contracts, or Credit Default Swaps (CDS), and for derivative assets written on such large portfolios, such as Mortgage Backed Securities, Collateralized Debt Obligations, derivatives on a CDS index (such as itraxx, or CDX), Insurance Linked Securities, or longevity bonds. The value of a portfolio risk measure is often difficult to derive even numerically due to i) the large size of the support portfolio, which can include from about one hundred to several thousands of individual contracts; ii) the nonlinearity of individual risks, such as default, recovery, claim occurrence, prepayment, surrender, lapse; iii) the need to take into account the dependence between individual risks induced by the systematic components of these risks. The granularity principle has been introduced for static single factor models during the discussion on the New Basel Capital Accord [BCBS (200)], following the contributions by Gordy (2003) and Wilde (200). The granularity principle allows for closed form expressions of the risk measures for large portfolios at order /n, where n denotes the portfolio size. More precisely, any portfolio risk measure can be decomposed as the sum of an asymptotic risk measure corresponding to an infinite portfolio size and /n times an adjustment term. The asymptotic portfolio risk measure, called Cross-Sectional Asymptotic (CSA) risk measure, captures the non diversifiable effect of systematic risks on the portfolio. The adjustment term, called Granularity Adjustment (GA), summarizes the effect of the individual specific risks and their cross-effect with systematic risks, The number of names included in the itraxx Europe, or CDX North American Investment Grade indexes, is 25. 3

when the portfolio size is large, but finite. Despite its analytical tractability and intuitive appeal, the static single risk factor model is too restrictive to capture the complexity and dynamics of systematic risks. For instance, multiple dynamic factors are needed for a joint analysis of stochastic drift and volatility of asset returns, and of default and loss given default of corporate loans in large portfolios. Such a more general framework is also useful to model country and industrial sector specific effects, to monitor the risk of loans with guarantees, when the guarantors themselves can default [Ebert, Lutkebohmert (2009)], or to distinguish between trend and cycle effects. Motivated by these applications, the purpose of our paper is to extend the granularity approach to a dynamic multiple factor framework. In order to ease the exposition of the paper, the presentation of the results is organized in two steps. We first introduce the static multiple risk factor model in Section 2. In this framework, the granularity adjustment of the VaR is given in Section 3. The GA for the VaR can be used to derive easily the GA for any other Distortion Risk Measure, including for instance Expected Shortfall. Section 4 provides the granularity adjustment for a variety of static single and multiple risk factor models considered in applications. In a second step, the analysis is extended to dynamic risk factor models in Section 5. In the dynamic framework, two granularity adjustments are required. The first GA concerns the conditional VaR with current factor value assumed to be observed. The second GA takes into account the unobservability of the current factor value. This new decomposition relies on recent results on the granularity principle applied to nonlinearing filtering problems [Gagliardini, Gouriéroux (200)a]. Whereas the initial version of the Basel 2 regulation has focused on modeling the stochastic probability of default assuming a deterministic loss given default, the most advanced approaches have to account for the uncertainty in the recovery rate and its correlation with the probability of default. Thus, in Section 6 we introduce a dynamic twofactor model with stochastic probability of default and loss given default, and derive the patterns of the granularity adjustment. Section 7 concludes. The theoretical derivations of the granularity adjustments are done in the Appendices. 4

2 Static Risk Factor Model In the static risk factor model we focus on the contemporaneous dependence structure between the individual risks in the portfolio. For expository purpose, we omit the unnecessary time index. 2. Homogenous Portfolio Let us assume that the individual risks (e.g. asset values, or default indicators) depend on some common factors and on individual specific effects: y i = c(f, u i ), i =,...,n, (2.) where y i denotes the individual risk, F the systematic factor and u i the idiosyncratic term. Both F and u i can be multidimensional, whereas y i is one-dimensional. Variables F and u i satisfy the following assumptions: Distributional Assumptions: For any portfolio size n: A.: F and (u,...,u n ) are independent. A.2: u,...,u n are independent and identically distributed. The portfolio of individual risks is homogenous, since the joint distribution of (y,...,y n ) is invariant by permutation of the n individuals, for any n. This exchangeability property of the individual risks is equivalent to the fact that variables y,...,y n are independent, identically distributed conditional on some factor F [de Finetti (93), Hewitt, Savage (955)]. When the unobservable systematic factor F is integrated out, the individual risks become dependent. 2.2 Examples We describe below simple examples of static Risk Factor Model (RFM) (see Section 4 for further examples). Example 2.: Linear Single-Factor Model We have: y i = F + u i, 5

where the specific error terms u i are Gaussian N(0,σ 2 ) and the factor F is Gaussian N(μ, η 2 ). Since Corr (y i,y j )=η 2 /(η 2 +σ 2 ), for i j, the common factor creates the (positive) dependence between individual risks, whenever η 2 0. This model has been used rather early in the literature on individual risks. For instance, it is the Buhlmann model considered in actuarial science and is the basis for credibility theory [Buhlmann (967), Buhlmann, Straub (970)]. Example 2.2: The Single Risk Factor Model for Default The individual risk is the default indicator, that is y i =, if there is a default of individual i, and y i =0, otherwise. This risk variable is given by:, if F + u i < 0, y i = 0, otherwise, where F N(μ, η 2 ) and u i N(0,σ 2 ). The quantity F + u i is often interpreted as a log asset/liability ratio, when i is a company [see e.g. Merton (974), Vasicek (99)]. Thus, the company defaults when the asset value becomes smaller than the amount of debt. Factor F is the systematic component in the asset/liability ratios of the firms in the portfolio. The basic specifications in Examples 2. and 2.2 can be extended by introducing additional unobserved individual heterogeneity, or multiple factors. Example 2.3: Model with Stochastic Drift and Volatility The individual risks are such that: y i = F +(expf 2 ) /2 u i, where F (resp. F 2 ) is a common stochastic drift factor (resp. stochastic volatility factor). When y i is an asset return, we expect factors F and F 2 to be dependent, since the (conditional) expected return generally contains a volatility risk premium. Example 2.4: Linear Single Risk Factor Model with Beta Heterogeneity This is a linear factor model, in which the individual risks may have different sensitivities (called betas) to the systematic factor. The model is: y i = β i F + v i, 6

and u i =(β i,v i ) is bidimensional. In particular, the betas are assumed unobservable and are included among the idiosyncratic risks. This type of model is the basis of the Arbitrage Pricing Theory (APT) [see e.g. Ross (976), and Chamberlain, Rothschild (983), in which similar assumptions are introduced on the beta coefficients]. 3 Granularity Adjustment for Portfolio Risk Measures 3. Portfolio Risk Let us consider an homogenous portfolio including n individual risks. The total portfolio risk is: W n = n y i = i= n c(f, u i ). (3.) i= The total portfolio risk can correspond to a profit and loss (P&L), for instance when y i is an asset return and W n /n the equally weighted portfolio return. In other cases, it corresponds to a loss and profit (L&P), for instance when y i is a default indicator and W n /n the portfolio default frequency 2. As usual, we pass from a P&L to a L&P by a change of sign 3. The quantile of W n atagiven risk level is used to define a VaR (resp. the opposite of a VaR), if W n is a L&P (resp. a P&L). The distribution of W n is generally unknown in closed form due to the risks dependence and the aggregation step. The density of W n involves integrals with a large dimension, which can reach dim(f )+ndim(u). Therefore, the quantiles of the distribution of W n, can also be difficult to compute 4. To address this issue we consider a large portfolio perspective. 2 The results of the paper are easily extended to obligors with different exposures A i, say. In this case we have n n n W n = A i y i = A i c(f, u i )= c (F, u i ), where the idiosyncratic risks u i =(u i,a i ) contain the individual i= i= i= shocks u i and the individual exposures A i [see e.g. Emmer, Tasche (2005) in a particular case]. 3 This means that asset returns will be replaced by opposite asset returns, that are returns for investors with short positions. 4 The VaR can often be approximated by simulations [see e.g. Glasserman, Li (2005)], but these simulations are very time consuming, if the portfolio size is large and the risk level of the VaR is small, especially in dynamic factor models. 7

3.2 Asymptotic Portfolio Risk The standard limit theorems such as the Law of Large Numbers (LLN) and the Central Limit Theorem (CLT) cannot be applied directly to the sequence y,...,y n due to the common factors. However, LLN and CLT can be applied conditionally on the factor values, under Assumptions A. and A.2. This is the condition of infinitely fine grained portfolio 5 in the Basel 2 terminology [BCBS (200)]. Let us denote by m(f )=E[y i F ]=E[c(F, u i ) F ], (3.2) the conditional individual expected risk, and σ 2 (F )=V[y i F ]=V[c(F, u i ) F ], (3.3) the conditional individual volatility. By applying the CLT conditional on F, we get: W n /n = m(f )+σ(f) X + O(/n), (3.4) n where X is a standard Gaussian variable independent of factor F. The term at order O(/n) is zero mean, conditional on F, since W n /n is a conditionally unbiased estimator of m(f ). Expansion (3.4) differs from the expansion associated with the standard CLT. Whereas the first term of the expansion is constant, equal to the unconditional mean in the standard CLT, it is stochastic in expansion (3.4) and linked with the second term of the expansion by means of factor F. Moreover, each term in the expansion depends on the factor value, but also on the distribution of idiosyncratic risk by means of functions m(.) and σ(.). By considering expansion (3.4), the initial model with dim(f ) +n dim(u) dimensions of uncertainty is approximated by a 3-dimensional model, with uncertainty summarized by means of m(f ), σ(f ) and X. 3.3 Granularity principle The granularity principle has been introduced for static single risk factor models by Gordy in 2000 for application in Basel 2 [Gordy (2003)]. We extend below this principle to multiple factor 5 Loosely speaking, the portfolio is infinitely fine grained, when the largest individual exposure accounts for an infinitely small share of the total portfolio exposure [Ebert, Lutkebohmert (2009)]. This condition is satisfied under Assumptions A. and A.2. 8

models. The granularity principle requires several steps, which are presented below for a loss and profit variable. i) A standardized risk measure Instead of the VaR of the portfolio risk, which explodes with the portfolio size, it is preferable to consider the VaR per individual risk (asset) included in this portfolio. Since by Assumptions A.- A.2 the individuals are exchangeable and a quantile function is homothetic, the VaR per individual risk is simply a quantile of W n /n. The VaR at risk level α = α is denoted by VaR n (α) and is defined by the condition: P [W n /n < V ar n (α)] = α, (3.5) where α is a positive number close to, typically α = 95%, 99%, 99.9%, which correspond to probabilities of large losses equal to α =5%, %, 0.%, respectively. ii) The CSA risk measure Vasicek [Vasicek (99)] proposed to first consider the limiting case of a portfolio with infinite size. Since lim W n/n = m(f ), a.s., (3.6) n the infinite size portfolio is not riskfree. Indeed, the systematic risk is undiversifiable. We deduce that the CSA risk measure: VaR (α) = lim VaR n (α), (3.7) n is the α-quantile associated with the systematic component of the portfolio risk: P [m(f ) <VaR (α)] = α. (3.8) The CSA risk measure is suggested in the Internal Ratings Based (IRB) approach of Basel 2 for minimum capital requirement. This approach neglects the effect of unsystematic risks in a portfolio of finite size. iii) Granularity Adjustment for the risk measure The main result in granularity theory applied to risk measures provides the next term in the asymptotic expansion of VaR n (α) with respect to n, for large n. It is given below for a multiple factor model. 9

Proposition : In a static RFM, we have: VaR n (α) =VaR (α)+ n GA(α)+o(/n), where: GA(α) = { d log g 2 dw [VaR (α)]e[σ 2 (F ) m(f )=VaR (α)] + d } dw E[σ2 (F ) m(f )=w] w=var (α) = 2 E [ σ 2 (F ) m(f )=VaR (α) ] { d log g dw [VaR (α)] + d dw log E [ σ 2 (F ) m(f )=w ] }, w=var (α) and g [resp. VaR (.)] denotes the probability density function (resp. the quantile function) of the random variable m(f ). Proof: See Appendix. The GA in Proposition depends on the tail magnitude of the systematic risk component m(f ) by means of d log g dw [VaR (α)], which is expected to be negative. The GA depends also on d dw log E [ σ 2 (F ) m(f )=w ] which is a measure of the reaction of the individual w=var (α), volatility to shocks on the individual drift. When y i,t is the opposite of an asset return, this reaction function is expected to be nonlinear and increasing for positive values of m(f ), according to the leverage effect interpretation [Black (976)]. When the tail effect is larger than the leverage effect, the GA is positive, which implies an increase of the required capital compared to the CSA risk measure. In the special case of independent stochastic drift and volatility, the GA reduces to GA(α) = 2 E [ σ 2 (F ) m(f )=VaR (α) ] d log g dw [VaR (α)], which is positive for large α. The adjustment involves both the tail of the systematic risk component and the expected conditional variability of the individual risks. The asymptotic expansion of the VaR in Proposition is important for several reasons. i) The computation of quantities VaR (α) and GA(α) does not require the evaluation of large dimensional integrals. Indeed, VaR (α) and GA(α) involve the distribution of transformations m(f ) and σ 2 (F ) of the systematic factor only, which are independent of the portfolio size n. 0

ii) The second term in the expansion is of order /n, and not / n as might have been expected from the Central Limit Theorem. This implies that the approximation VaR (α) + GA(α) is n likely rather accurate, even for rather small values of n such as n = 00. iii) The expansion is valid for single as well as multiple factor models. iv) The expansion is easily extended to the other Distortion Risk Measures, which are weighted averages of VaR: DRM n (H) = VaR n (u)dh(u), say, where H denotes the distortion measure [Wang (2000)]. The granularity adjustment for the DRM is simply: GA(u)dH(u). n In particular, the Expected Shortfall at confidence level α corresponds to the distortion measure with cumulative distribution function H(u; α) =(u α) + /( α), and the granularity adjustment is GA(u)du, n( α) α that is an average of the granularity adjustments for VaR above level α. v) Proposition can be used to investigate the difficult task of aggregation of risk measures. In Appendix 2 we derive the granularity adjustment for the VaR of an heterogeneous portfolio which can be partitioned into a finite number of homogenous subportfolios. We assume that the heterogeneity is due to some unobservable characteristic of the individual risks admitting a finite number of alternatives. We relate the granularity approximation of the heterogenous portfolio VaR to the risk measures of the different homogeneous subpopulations. 4 Examples This section provides the closed form expressions of the GA for the examples introduced in Section 2. We first consider single factor models, in which the GA formula is greatly simplified, then models with multiple factor.

4. Single Risk Factor Model In a single factor model, the factor can generally be identified with the expected individual risk: m(f )=F. (4.) Then, VaR (α) is the α-quantile of factor F and g is its density function. The granularity adjustment of the VaR becomes: GA(α) = { } d log g 2 df [VaR (α)]σ 2 [VaR (α)] + dσ2 df [VaR (α)]. (4.2) This formula has been initially derived by Wilde (200) [see also Martin, Wilde (2002), Gordy (2003, 2004)], based on the local analysis of the VaR [Gouriéroux, Laurent, Scaillet (2000)] and Expected Shortfall [Tasche (2000)]. 6 Example 4.: Linear Single Risk Factor Model [Gordy (2004)] In the linear model y i = F + u i, with F N(μ, η 2 ) and u i N(0,σ 2 ),wehavem(f)=f, σ 2 (F )=σ 2, g (F )= ( ) F μ η ϕ, and VaR (α) =μ + ηφ (α), where ϕ (resp. Φ) is the η density function (resp. cumulative distribution function) of the standard normal distribution. We deduce: GA(α) = σ2 2 d log g df [VaR (α)] = σ2 2η Φ (α). In this simple Gaussian framework, the quantile VaR n (α) is known in closed form, and the above GA corresponds to the first-order term in a Taylor expansion of VaR n (α) w.r.t. /n. Indeed, we have W n /n N (μ, η 2 + σ 2 /n) and: VaR n (α) =μ + η 2 + σ2 n Φ (α) =μ + ηφ (α)+ σ 2 n 2η Φ (α)+o(/n). As expected the GA is positive for large α, more precisely for α>0.5. The GA increases when the idiosyncratic risk increases, that is, when σ 2 increases. Moreover, the GA is a decreasing function of η, which means that the adjustment is smaller, when systematic risk increases. 6 When the factor F is not identified with the conditional mean m(f ), but the function m(.) is increasing, formula (4.2) becomes: GA(α) = d σ2 (F ) g (F ) 2 g (F ) df dm df (F ) where g is the density of F (see Appendix 3 for the derivation). 2 F =m (VaR (α)), (4.3)

Example 4.2: Static RFM for Default Let us assume that the individual risks follow independent Bernoulli distributions conditional on factor F : y i B(,F), where B(,p) denotes a Bernoulli distribution with probability p. This is the well-known model with stochastic probability of default, often called reduced form model or stochastic intensity model in the Credit Risk literature. In this case W n /n is the default frequency in the portfolio. It also corresponds to the portfolio loss given default, if the loans have a unitary nominal and a zero recovery rate. In this model we have m(f )=F, σ 2 (F )=F( F ), and we deduce: GA(α) = { } d log g 2 df [VaR (α)]var (α)[ VaR (α)] + 2VaR (α). (4.4) This formula appears for instance in Rau-Bredow (2005). Different specifications have been considered in the literature for stochastic intensity F. 7 Let us assume that there exists an increasing transformation A, say, from (, + ) to (0,) such that: A (F ) N(μ, η 2 ). (4.5) We get a logit (resp. probit) normal specification, when A is the cumulative distribution function of the the logistic distribution (resp. the standard normal distribution). A logit specification is used in CreditPortfolioView by Mc Kinsey, a probit specification is proposed in KMV/Moody s and CreditMetrics. Let us denote a(y) = da(y) the associated derivative. We have: dy VaR (α) = A[μ + ηφ (α)], ( d log g df [VaR Φ (α) (α)] = a[μ + ηφ (α)] η + d log a ) dy [μ + ηφ (α)]. (4.6) 7 Gordy (2004) and Gordy, Lutkebohmert (2007) derive the GA in the CreditRisk+ model [Credit Suisse Financial Products (997)], which has been the basis for the granularity adjustment proposed in the New Basel Capital Accord [see BCBS (200, Chapter 8) and Wilde (200)]. The CreditRisk+ model has some limitations. First, it assumes that the stochastic probability of default F follows a gamma distribution, that admits values of default probability larger than. Second, it assumes a constant expected loss given default. We present a multi-factor model with stochastic default probability and expected loss given default in Section 6. 3

i) In the logit normal reduced form, the transformation A (F )=log[f/( F )] corresponds to the log of an odd ratio, and the formula for the GA simplifies considerably: VaR (α) = In particular, the GA doesn t depend on parameter μ. +exp[ μ ηφ (α)], GA(α) = 2η Φ (α). ii) Let us now consider the structural Merton (974) - Vasicek (99) model [see Example 2.2]. This model can be written in terms of two structural parameters, that are the unconditional probability of default PD and the asset correlation ρ, such as: y i =l Φ (PD)+ ρf + ρu i < 0, where F and u i, for i =,,n, are independent standard Gaussian variables. The structural factor F is distinguished from the reduced form factor F which is the stochastic probability of default. They are related by: Φ (F )= Φ (PD) ρ ρ ρ F. From (4.5) we deduce that: μ = Φ (PD) ρ, η = ρ ρ. (4.7) Thus, from (4.4)-(4.7) we deduce the CSA VaR [Vasicek (99)]: ( Φ (PD)+ ρφ ) (α) VaR (α) =Φ, (4.8) ρ and the granularity adjustment (see Appendix 4): ρ GA(α) = ρ Φ (α) Φ [VaR (α)] VaR 2 φ (Φ (α)[ VaR (α)] + 2VaR (α). [VaR (α)]) (4.9) Equation (4.9) is similar to formula (2.7) in Emmer, Tasche (2005) [see also Gordy, Marrone (200), equation (5)], but is written in a way that shows how the GA depends on the unconditional probability of default PD and asset correlation ρ. This dependence occurs through the term ( ρ)/ρ and the CSA quantile VaR (α). 4

In Figure we display the CSA quantile VaR (α) and the granularity adjustment per contract GA(α) as functions of asset correlation ρ and for different values of the unconditional probability of default, that are PD =0.5%, %, 5%, and 20%, respectively. These values of PD n are representative for the default probabilities of a firm with rating BBB, BB, B and C, respectively, in the rating system by S&P. The confidence level is α =0.99 and the portfolio size is n = 000. [Insert Figure : CSA CreditVaR and granularity adjustment as functions of the asset correlation in the Merton-Vasicek model.] The CSA VaR is monotone increasing w.r.t. asset correlation ρ when the probability of default is such that PD α; for PD < α, the CSA VaR is not monotone w.r.t. ρ and it converges to zero as ρ approaches. In the interval of asset correlation values ρ [0.2, 0.24] considered for obligors in the Basel 2 regulation [see BCBS(200)], the CSA VaR is about 0.05 for obligors with PD =%, while the GA per contract is about 0.005 for n = 000 (and 0.05 for n = 00). Thus, the magnitude of the GA can be significant w.r.t. the CSA VaR. The granularity adjustment is decreasing w.r.t. asset correlation ρ, when ρ is not close to. In Figure 2 we display the CSA quantile VaR (α) and the granularity adjustment per contract GA(α) as functions of probability of default PDand for different values of the asset correlation, n that are ρ =0.05, 0.2, 0.24, and 0.50, respectively. [Insert Figure 2: CSA CreditVaR and granularity adjustment as functions of the unconditional probability of default in the Merton-Vasicek model.] The CSA VaR is monotone increasing w.r.t. the probability of default PD. The granularity adjustment features an inverse-u shape. The maximum GA occurs for values of PD corresponding to speculative grade ratings, when ρ is between 0.2 and 0.24. Example 4.3: Linear Static RFM with Beta Heterogeneity Let us consider the model of Example 2.4. We have y i = β i F + v i, where F N(μ, η 2 ), v i N(0,σ 2 ), and β i N(,γ 2 ), with all these variables independent. Due to a problem of factor identification, the mean of β i can always be fixed to. This also facilitates the comparison 5

with the model with constant beta of Example 4.. We get m(f )=F, σ 2 (F )=σ 2 + γ 2 F 2, and: [ ] GA(α) = σ2 2η Φ (α)+γ 2 VaR (α) 2 Φ (α) VaR (α), (4.0) 2η where VaR (α) =μ + ηφ (α). Thus, the CSA risk measure VaR (α) is computed in the homogenous model with factor sensitivity β =. The granularity adjustment accounts for beta heterogeneity in the portfolio through the variance γ 2 of the heterogeneity distribution. More precisely, the first term in the RHS of (4.0) is the GA already derived in Example 4., whereas the second term is specific of the beta heterogeneity. 4.2 Multiple Risk Factor Model Example 4.4: Stochastic Drift and Volatility Model Let us assume that y i N(F, exp F 2 ), conditional on the bivariate factor F =(F,F 2 ), and that F N, η2 ρη η 2. μ 2 ρη η 2 η2 2 This type of stochastic volatility model is standard for modelling the dynamic of asset returns, or equivalently of opposite asset returns. We can introduce the regression equation: F 2 = μ 2 + ρη 2 η (F μ )+v, where v is independent of F, with Gaussian distribution N[0,η 2 2( ρ 2 )]. Wehavem(F )=F, VaR (α) =μ + η Φ (α), σ 2 (F )=exp(f 2 ), and In particular: E[σ 2 (F ) m(f )] = E[exp F 2 F ]=E[exp{μ 2 + ρη 2 (F μ )+v} F ] η [ = exp μ 2 + ρη ] 2 (F μ ) E[exp(v)] η = exp d dw log E [ σ 2 (F ) m(f )=w ] = [ μ 2 + ρη 2 (F μ )+ η2 2( ρ 2 ) η 2 6 ]. d df log E [F 2 F ]= ρη 2 η.

When y i is the opposite of an asset return, a positive value ρ > 0, i.e. a negative correlation between return and volatility, can represent a leverage effect. From Proposition, we deduce that: GA(α) = [ ] [Φ (α) ρη 2 ]exp[μ 2 + η 2 2η 2/2] exp ρη 2 Φ (α)+ ρ2 η2 2. 2 The GA of the linear single-factor RFM (see Example 4.) is obtained when either factor F 2 is constant (η 2 =0), or factors F and F 2 are independent (ρ =0), by noting that E[exp F 2 ]= exp[μ 2 + η 2 2/2]. In Figure 3 we display the CSA VaR and GA VaR as functions of the correlation ρ. [Insert Figure 3: CSA VaR and GA VaR in the stochastic drift and volatility model as functions of the correlation between the factors.] The parameters μ = 0.0, η =0.067, μ 2 = 4.0224 and η 2 =0.0 are such that the unconditional mean and standard deviations of the opposite asset returns are 0.0 and 0.5, respectively, while the correlation between the returns of different assets is equal to 0.20. For portfolio size n =25and confidence level α =0.99, the CSA and GA VaR are quite close. The granularity adjustment is increasing w.r.t. the correlation ρ. 5 Dynamic Risk Factor Model (DRFM) The static risk factor model implicitly assumes that the past observations are not informative to predict the future risk. In dynamic factor models, the VaR becomes a function of the available information. This conditional VaR has to account for the unobservability of the current and lagged factor values. We show in this section that factor unobservability implies an additional GA for the VaR. Despite this further layer of complexity in dynamic models, the granularity principle becomes even more useful compared to the static framework. Indeed, the conditional cdf of the portfolio value at date t involves an integral that can reach dimension (t +)dim(f )+ndim(u), which now depends on t, due to the integration w.r.t. the factor path. 5. The Model Dynamic features can easily be introduced in the following way: 7

i) We still assume a static relationship between the individual risks and the systematic factors. This relationship is given by the static measurement equations: y it = c(f t,u it ), (5.) where the idiosyncratic risks (u i,t ) are independent, identically distributed across individuals and dates, and independent of the factor process (F t ). ii) Then, we allow for factor dynamic. The factor process (F t ) is Markov with transition pdf g(f t f t ), say. Thus, all the dynamics of individual risks pass by means of the factor dynamic. n Let us now consider the future portfolio risk per individual asset defined by W n,t+ /n = n y i,t+. The (conditional) VaR at horizon is defined by the equation: i= P [W n,t+ /n < V ar n,t (α) I n,t ]=α, (5.2) where the available information I n,t includes all current and past individual risks y i,t,y i,t,..., for i =,...,n, but not the current and past factor values. The conditional quantile VaR n,t (α) depends on date t through the information I n,t. 5.2 Granularity Adjustment i) Asymptotic expansion of the portfolio risk Let us first perform an asymptotic expansion of the portfolio risk. By the cross-sectional CLT applied conditional on the factor path, we have: W n,t+ /n = m(f t+ )+σ(f t+ ) X t+ n + O(/n), where the variable X t+ is standard normal, independent of the factor process, and O(/n) denotes a term of order /n, which is zero-mean conditional on F t+,f t,. The functions m(.) and σ 2 (.) are defined analogously as in (3.2)-(3.3), and depend on F t+ only by the static measurement equations (5.). In order to compute the conditional cdf of W n,t+ /n, it is useful to reintroduce the current 8

factor value in the conditioning set through the law of iterated expectation. We have: P [W n,t+ /n < y I n,t ] = E[P (W n,t+ /n < y F t,i n,t ) I n,t ] = E[P (W n,t+ /n < y F t ) I n,t ] = E[P (m(f t+ )+σ(f t+ ) X t+ n + O(/n) <y F t ) I n,t ] = E[a(y, X t+ n + O(/n); F t ) I n,t ], (5.3) where function a is defined by: a(y, ε; f t )=P [m(f t+ )+σ(f t+ )ε<y F t = f t ]. (5.4) ii) Cross-sectional approximation of the factor Function a depends on the unobserved factor value F t = f t, and we have first to explain how this value can be approximated from observed individual variables. For this purpose, let us denote by h(y i,t f t ) the conditional density of y i,t given F t = f t, deduced from model (5.), and define the cross-sectional maximum likelihood approximation of f t given by: ˆf n,t = arg max f t n log h(y i,t f t ). (5.5) i= The factor value f t is treated as an unknown parameter in the cross-sectional conditional model at date t and is approximated by the maximum likelihood principle. Approximation ˆf nt is a function of the current individual observations and hence of the available information I n,t. iii) Granularity Adjustment for factor prediction It might seem natural to replace the unobserved factor value f t by its cross-sectional approximation ˆf n,t in the expression of function a, and then to use the GA of the static model in Proposition, for the distribution of F t+ given F t = ˆf n,t. However, replacing f t by ˆf n,t implies an approximation error. It has been proved that this error is of order /n, that is, the same order expected for the GA. More precisely, we have the following result which is given in the single factor framework for expository purpose [Gagliardini, Gouriéroux (200a), Corollary 5.3]: 9

Proposition 2: Let us consider a dynamic single factor model. For a large homogenous portfolio, the conditional distribution of F t given I n,t is approximately normal at order /n: ( N ˆf n,t + n μ n,t, ) n J n,t, where: μ n,t = Jn,t log g f t J n,t = n n i= K n,t = n n i= ( ˆf n,t ˆf n,t )+ 2 J 2 n,t K n,t, 2 log h (y ft 2 i,t ˆf n,t ), 3 log h (y ft 3 i,t ˆf n,t ). Proposition 2 gives an approximation of the filtering distribution of factor F t given the information I n,t. Both mean and variance are approximated at order /n to apply an Ito s type correction. The approximation involves four summary statistics, which are the cross-sectional maximum likelihood approximations ˆf n,t and ˆf n,t, the Fisher information J n,t for approximating the factor in the cross-section at date t, and the statistic K n,t involved in the bias adjustment. iii) Expansion of the cdf of portfolio risk as: From equation (5.3) and Proposition 2, the conditional cdf of the portfolio risk can be written P [W n,t+ /n < y I n,t ]=E [ ( a y, X t+ + O(/n); ˆf n,t + n n μ n,t + J /2 n n,t X t ) I n,t ] + o(/n), where X t is a standard Gaussian variable independent of X t+ and O(/n), of the factor path and of the available information 8. Then, we can expand the expression above with respect to n, up to order /n. By noting that ˆfn,t, μ n,t, J n,t are functions of the available information and that E[X t+ ] = E[X t ] = E[O(/n)] = 0, E[X t+ X t ]=0, E[X 2 t+] =E[(X t ) 2 ]=, we get: P [W n,t+ /n < y I n,t ] = a(y, 0; ˆf n,t )+ n [ + Jn,t 2n a(y, 0; ˆf nt ) μ nt f t 2 a(y, 0; ˆf n,t ) f 2 t + 2 a(y, 0, ˆf nt ) ε 2 ] + o(/n). 8 The independence between Xt and X t+ is due to the fact that Xt simply represents the numerical approximation of the filtering distribution of F t given I n,t and is not related to the stochastic features of the observations at t +[see Gagliardini, Gouriéroux (200a)]. 20

The CSA conditional cdf of the portfolio risk is a(y, 0; ˆf n,t ), where: a(y, 0; f t )=P [m(f t+ ) <y F t = f t ]. (5.6) It corresponds to the conditional cdf of m(f t+ ) given F t = f t, where the unobservable factor value f t is replaced by its cross-sectional approximation ˆf n,t. The GA for the cdf is the sum of the following components: i) The granularity adjustment for the conditional cdf with known F t equal to ˆf n,t is 2 a(y, 0; ˆf n,t ). (5.7) 2n ε 2 The second-order derivative of function a(y, ε; f t ) w.r.t. ε at ε =0can be computed by using Lemma a. in Appendix, which yields: 2 a(y, 0; f t ) ε 2 = d { g (y; f t )E[σ 2 (F t+ ) m(f t+ )=y, F t = f t ] }, dy where g (y; f t ) denotes the pdf of m(f t+ ) conditional on F t = f t. ii) The granularity adjustment for filtering is a(y, 0; ˆf n,t ) f t μ nt + 2 J n,t 2 a(y, 0; ˆf nt ). (5.8) ft 2 It involves the first- and second-order derivatives of the CSA cdf w.r.t. the conditioning factor value. Due to the independence between variables X t+ and X t, there is no cross GA. iv) Granularity Adjustment for the VaR The CSA cdf is used to define the CSA risk measure VaR (α; ˆf n,t ) through the condition: P [m(f t+ ) <VaR (α; ˆf n,t ) F t = ˆf ] n,t = α. The CSA VaR depends on the current information through the cross-sectional approximation of the factor value ˆf n,t only. The GA for the (conditional) VaR is directly deduced from the GA of the (conditional) cdf by applying the Bahadur s expansion [Bahadur (966); see Lemma a.3 in Appendix ]. We get the next Proposition: Proposition 3: In a dynamic RFM the (conditional) VaR is such that: VaR n,t (α) =VaR (α; ˆf n,t )+ n [GA risk,t(α)+ga filt,t (α)] + o(/n), 2

where: GA risk,t (α) = 2 { log g (w; ˆf nt ) E[σ 2 (F t+ ) m(f t+ )=w, F t = w ˆf n,t ] } + w E[σ2 (F t+ ) m(f t+ )=w, F t = ˆf n,t ], w=var (α; ˆf n,t) and: { a[var (α, GA filt,t (α) = ˆf nt ), 0; ˆf nt ] g [VaR (α; ˆf n,t ); ˆf μ nt n,t ] f t + 2 J n,t 2 a[var (α; ˆf nt ), 0; ˆf } nt ], ft 2 and where g (.; f t ) [resp. a(., 0; f t ) and VaR (.; f t )] denotes the pdf (resp. the cdf and quantile) of m(f t+ ) conditional on F t = f t. Thus, the GA for the conditional VaR is the sum of two components. The first one GA risk,t (α) is the analogue of the GA in the static factor model (see Proposition ). However, the distribution of m(f t+ ) and σ 2 (F t+ ) is now conditional on F t = f t, and the unobservable factor value f t is replaced by its cross-sectional approximation ˆf n,t. The second component GA filt,t (α) is due to the filtering of the unobservable factor value, and involves first- and second-order derivatives of the CSA cdf w.r.t. the conditioning factor value. 5.3 Linear DRFM with AR() factor As an illustration, let us consider the model given by: y i,t = F t + u i,t, i =,...,n, and: F t = μ + ρ(f t μ)+v t, where shocks u i,t, v t are independent, and such that u it IIN(0,σ 2 ) and v t IIN(0,η 2 ). In this Gaussian framework the (conditional) VaR can be computed explicitly, which allows for a comparison with the granularity approximation in order to assess the accuracy of the two GA components and their (relative) magnitude. The individual observations can be summarized by their cross-sectional averages 9 and we 9 By writing the likelihood of the model, it is seen that the cross-sectional averages are sufficient statistics. 22

have: ȳ n,t+ = F t+ +ū n,t+, F t+ = μ + ρ(f t μ)+v t+, (5.9) where ȳ n,t = n n i= y i,t. The cross-sectional averages are the maximum likelihood approximations of the unobservable factor values, i.e. ˆfn,t =ȳ n,t. The state space model (5.9) describes the filtering of the unobservable factor values F t through the observable proxies ȳ n,t. The dynamics of the cross-sectional averages is derived in the next Proposition 4, which is proved in Appendix 5. Proposition 4: In the linear DRFM with AR() Gaussian factor, the cross-sectional approximations satisfy an ARMA(,) process with autoregressive representation: ȳ n,t+ = μ +(ρ θ n ) where the variables ε t are IIN(0,γ 2 n) and: with b n =+ρ 2 + n η2 σ 2. θn(ȳ j n,t j μ)+ε t+ j=0 θ n = b n b 2 n 4ρ 2, γn 2 = ρσ2, (5.0) 2ρ nθ n While the factor F t is a Markov process of order, its cross-sectional approximation ȳ n,t features a longer memory and follows an autoregressive process of infinite order. The weights of the past observations decay geometrically with the lag, as powers of parameter θ n. From Proposition 4, we immediately deduce the conditional VaR. Corollary 5: In the linear DRFM with AR() Gaussian factor, the conditional VaR is given by: VaR n,t (α) =μ +(ρ θ n ) where θ n and γ n are given in (5.0). θn(ȳ j n,t j μ)+γ n Φ (α), j=0 Thus, the conditional VaR depends on the information I n,t through a weighted sum of current and lagged cross-sectional individual risks averages. The information I n,t impacts the VaR uniformly in the risk level α. 23

Let us now derive the expansion of VaR n,t (α) at order /n for large n. From (5.0), the expansions of parameters θ n and γ n are: θ n = ρσ2 η 2 n + o(/n), γ n = η + σ2 2nη ( + ρ2 )+o(/n). As n, the MA parameter θ n converges to zero and the variance of the shocks γ 2 n converges to η 2. Hence, from Proposition 4 the ARMA(,) process of the cross-sectional averages ȳ n,t approaches the AR() factor process (F t ) as expected. By plugging the expansions for θ n and γ n into the expression of VaR n,t (α) in Corollary 5, we get: VaR n,t (α) = μ + ρ(ȳ n,t μ)+ηφ (α) + { σ 2 n 2η ( + ρ2 )Φ (α) ρσ2 η 2 The first row on the RHS provides the CSA VaR: } [(ȳ n,t μ) ρ(ȳ n,t μ)] + o(/n). VaR (α; ˆf n,t )=μ + ρ(ȳ n,t μ)+ηφ (α). (5.) which depends on the information through the cross-sectional factor approximation ˆf n,t = ȳ n,t. The CSA VaR is the quantile of the normal distribution with mean μ + ρ(ȳ n,t μ) and variance η 2, that is the conditional distribution of F t+ given F t =ȳ n,t. The GA involves the information I n,t through the current and lagged cross-sectional averages ȳ n,t and ȳ n,t. The other lagged values ȳ n,t j for j 2 are irrelevant at order o(/n). Let us now identify the risk and filtering GA components. We have: ( ) y μ ρ(ft μ) a(y, 0; f t ) = P (F t+ <y F t = f t )=Φ. η We deduce: and: g (y; f t )= a(y, 0; f t) y a(y, 0; f t ) f t = ρ η ϕ = [ ] y μ η ϕ ρ(ft μ), η [ y μ ρ(ft μ) η ], 2 a(y, 0; f t ) f 2 t = ρ2 η 2 [ y μ ρ(ft μ) η ] ϕ ( y μ ρ(ft μ) η ). 24

Moreover, the statistics involved in the approximate filtering distribution of F t given I n,t (see Proposition 2) are μ n,t = σ2 η [(ȳ 2 n,t μ) ρ(ȳ n,t μ)], J n,t =/σ 2 and K n,t =0. From Proposition 2 and equation (5.), we get: GA risk (α) = σ2 2η Φ (α), GA filt,t (α) = σ2 ρ 2 2η Φ (α) ρσ2 η [(ȳ 2 n,t μ) ρ(ȳ n,t μ)]. The GA for risk is the same as in the static model for ρ =0(see Example 4.), since in this Gaussian framework the current factor f t impacts the conditional distribution of m(f t+ )=F t+ given F t = f t through the mean only, and σ 2 (F t+ )=σ 2 is constant. The GA for filtering depends on both the risk level α and the information through (ȳ n,t μ) ρ(ȳ n,t μ). By the latter effect, GA filt,t (α) can take any sign. Moreover, this term induces a stabilization effect on the dynamics of the GA VaR compared to the CSA VaR. To see this, let us assume ρ>0 and suppose there is a large upward aggregate shock on the individual risks at date t, such that ȳ n,t μ is positive and (much) larger than ρ(ȳ n,t μ). The CSA VaR in (5.) reacts linearly to the shock and features a sharp increase. Since (ȳ n,t μ) ρ(ȳ n,t μ) > 0, the GA term for filtering is negative and reduces the reaction of the VaR. Intuitively, this correction of the risk measure through the GA filtering term accounts for the uncertainty in the cross-sectionally approximated factor value ˆf n,t. More specifically, it accounts for the possibility that the increase in the true value of the systematic factor F t is less pronounced than what suggested by the approximation ˆf n,t. In Figure 4 we display the patterns of the true, CSA and GA VaR curves as a function of the risk level for a specific choice of parameters. [Insert Figure 4: The VaR as a function of the risk level in the linear RFM with AR() factor.] The mean and the autoregressive coefficient of the factor are μ =0and ρ =0.5, respectively. The idiosyncratic and systematic variance parameters σ 2 and η 2 are selected in order to imply an unconditional standard deviation of the individual risks η 2 /( ρ 2 )+σ 2 =0.5, and an η 2 /( ρ 2 ) unconditional correlation between individual risks =0.0. The portfolio size σ 2 + η 2 /( ρ 2 ) is n = 00. The available information I n,t is such that ȳ n,t j = μ =0for all lags j 2, and we consider four different cases concerning the current and the most recent lagged cross-sectional averages, ȳ n,t and ȳ n,t, respectively. Let us first assume ȳ n,t =ȳ n,t =0(upper-left Panel), that 25

is, both cross-sectional averages are equal to the unconditional mean. As expected, all VaR curves are increasing w.r.t. the confidence level. The true VaR is about 0.0 at confidence level 99%. The CSA VaR underestimates the true VaR (that is, underestimates the risk) by about 0.0 uniformly in the risk level. The GA for risk corrects most of this bias and dominates the GA for filtering. The situation is different when ȳ n,t = 0.30 and ȳ n,t =0(upper-right Panel), that is, when we have a downward aggregate shock in risk of two standard deviations at date t. The CSA VaR underestimates the true VaR by about 0.02. The GA for risk corrects only a rather small part of this bias, while including the GA for filtering allows for a quite accurate approximation. The GA for filtering is about five times larger than the GA for risk. When ȳ n,t =0.30 and ȳ n,t =0(lower-left Panel), there is a large upward aggregate shock in risk at date t, and the CSA VaR overestimates the true VaR (that is, overestimates the risk). The GA correction for risk further increases the VaR and the bias, while including the GA correction yields a good approximation of the true VaR. The results are similar in the case ȳ n,t =0.30 and ȳ n,t =0.30 (lower-right Panel), that is, in case of a persistent downward aggregate shock in risk. Finally, by comparing the four panels in Figure 4, it is seen that the CSA risk measure is more sensitive to the current information than the true VaR and the GA VaR. Moreover, the relative importance of the GA correction w.r.t. the CSA VaR is more pronounced for small values of α, that is, for less extreme risks. To summarize, Figure 4 shows that the CSA VaR can either underestimate or overestimate the risk, the GA for filtering can dominate the GA for risk, and the complete GA can yield a good approximation of the true VaR even for portfolio sizes of some hundreds of contracts, at least in the specific linear RFM considered in this illustration. 6 Stochastic Probability of Default and Expected Loss Given Default A careful analysis of default risk has to consider jointly the default indicator and the Loss Given Default (LGD), i.e. one minus the recovery rate. The joint dynamics of the associated dated probability of default and expected loss given default have been studied in a limited number of papers. A well-known stylized fact is the positive correlation between probability of default and 26

loss given default [see e.g. Altman, Brady, Resti, Sironi (2005)]. However, this correlation is a crude summary statistic of the link between the two variables. This link is better understood by introducing time-varying determinants. Observable determinants considered in the literature include the business cycle, the GDP growth rate [see Bruche, Gonzalez-Agrado (200)], but also the rate of unemployment [Grunert, Weber (2009)]. In fact there exist arguments for a negative link in some circumstances. For instance, the bank has the possibility to declare the default of a borrower when such a default is expected, even if the interest on the debt continues to be regularly paid by the borrower. A too prudent bank can declare defaulted a borrower able to pay the remaining balance, and then create artificially a kind of prepayment. In such a case the probability of default increases and the loss given default decreases, which implies a negative link between the two risk variables. To capture such complicated effects and their dynamics in the required capital, it is necessary to consider a model with at least two factors. As in the previous sections, these two factors are assumed unobservable, since the uncertainty in their future evolution has to be taken into account in the reserve amount. 6. Two-factor dynamic model Let us consider a portfolio invested in zero-coupon corporate bonds with a same time-to-maturity and identical exposure at default. The loss on the zero-coupon corporate bond maturing at t +is: y i,t+ = LGD i,t+ Z i,t+, where Z i,t+ is the default indicator and LGD i,t+ is the loss given default. Conditional on the path of the bivariate factor F t =(F,t,F 2,t ), the default indicator Z i,t+ and the loss given default LGD i,t+ are independent, such that Z i,t+ B(,F,t+ ) and LGD i,t+ admits a beta distribution Beta(a t+,b t+ ) with conditional mean and volatility given by: E [LGD i,t+ F t+ ]=F 2,t+, V [LGD i,t+ F t+ ]=γf 2,t+ ( F 2,t+ ), where the concentration parameter γ (0, ) is constant. The parameters of the beta conditional distribution of LGD i,t+ are a t+ =(/γ ) F 2,t+ and b t+ =(/γ ) ( F 2,t+ ). The concentration parameter γ measures the variability of the conditional distribution of LGD i,t+ given F t+ taking into account that the variance of a random variable on [0, ] with mean μ, say, 27

is upper bounded by μ ( μ). 0 When the conditional concentration parameter γ approaches 0, the beta distribution degenerates to a point mass; when the conditional concentration parameter γ approaches the beta distribution converges to a Bernoulli distribution. The dynamic factors F,t and F 2,t correspond to the conditional probability of default and the conditional expected LGD, respectively. The effect of factor F 2 on the beta distribution of expected loss given default is illustrated in Figure 5. [Insert Figure 5: Conditional distribution of LGD i,t given F t.] The factor impacts both the location and shape of the distribution. Both stochastic factors F,t and F 2,t admit values in the interval (0, ). We assume that the transformed factors F t =(F,t,F 2,t) defined by F l,t =log[f l,t/( F l,t )], for l =, 2 (logistic transformation), follow a bivariate Gaussian VAR() process: with ε t IIN(0, Ω) and Ω= given in Table. F t = c +ΦFt + ε t, σ2 ρσ σ 2 ρσ σ 2 σ2 2. The parameters of the factor dynamics are Table : Parameters of the factor dynamics c c 2 Φ Φ 2 Φ 2 Φ 22 σ σ 2 ρ γ S.57 0.90 0.5 0 0 0.5 0.386 0.655 0.5 0.0 S 2.57 0.032 0.5 0 0 0.5 0.386 0.66 0.5 0.0 We consider two parameter sets S and S 2, that correspond to different values of the correlation ρ between shocks in the two transformed factors, namely 0.5 and 0.5, respectively. Thus, we 0 This shows that the mean and the variance cannot be fixed independently for the distribution of a random variable on [0, ]. In the standard credit risk models, the LGD is often assumed constant. In such a case the LGD coincides with both its conditional and unconditional expectations. In our framework the LGD is stochastic as well as its conditional expectation. 28