Simple Correlated Binomial Portfolio Loss Distribution

Abstract

In the quantitative analysis of the credit risk of a portfolio of bonds and loans, one industry approach imposes pairwise correlation directly on the defaults of the debt instruments in order to approximate the portfolio loss distribution. A leading credit rating agency applies a correlated binomial model for this purpose. Motivated by this example, we create two alternative correlated binomial models. We demonstrate through comparative calculations that one of these alternatives, a mixture of two zero-correlation binomial models, is superior among these three models. This mixed binomial model is also far simpler in its logical foundation and mathematical expression. We also find that the rating agency model is conceptually flawed and produces unsuitable credit loss distribution results.

TOPICS: Fixed income and structured finance, credit risk management