Tuesday, February 9, 2010

Copula-Based Formulas to Estimate Unexpected Credit Losses

By Fernando Francis Moreira:

Abstract: The model used to estimate the capital required to cover unexpected credit losses in financial institutions (Basel II) has some drawbacks that reduce its ability to capture potential joint extreme losses in downturns.

This paper suggests an alternative approach based on Copula Theory to overcome such flaws. Similarly to Basel II, the suggested model assumes that defaults are driven by a latent variable which varies as a response to an unobserved factor. On the other hand, the use of copulas allows the identification of asymmetric dependence between defaults which has been registered in the literature.

As an example, a specific copula family (Clayton) is adopted to represent the association between the latent variables and a formula to estimate potential unexpected losses at a certain level of confidence is derived.

Simulations reveal that, in most of the cases, the alternative model outperforms Basel II for portfolios with right-tail-dependent probabilities of default (supposedly, a good representation for loan portfolios).

Download the paper here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1545325

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