Business cycle effects on portfolio credit risk: A simple FX Adjustment for a factor model

The recent economic crisis on the demand side of the economy affects the trends and volatilities of the exchange rates as well as the operating conditions of borrowers in emerging market economies. But the exchange rate depreciation creates both winners and losers. With a weaker exchange rate, exporters and net holders of foreign assets will benefit, and vice verse, those relying on import and net debtors in foreign currency will be hurt. This paper presents a simple FX adjustment framework within Factor Endogenous Behaviour Aggregation (FEBA) approach* based on the decomposition of the competitiveness factor into components with meaningful behaviour content and subsequent collapsing into the Adjustment Index. The setup, while being simple, nicely captures non-linear and non-symmetric nature of the FX risk impact on bank’s credit portfolio and could be very useful for modeling credit risk. *The approach was set up in “Interaction between market and credit risk: Focus on the endogeneity of aggregate risk” and mentioned in Roubini Global Economic Digest as “Advance in Credit Risk Management”.