Starting from the Merton framework for firm defaults, we provide the analytics and robustness of the relationship between default correlations. We show that loans with higher default probabilities will not only have higher variances but also higher correlations between loans. As a consequence,...

In this paper we focus on the analysis of the effect of prediction and estimation risk on the loss distribution, risk measures and economic capital. When variables for the determination of probability of default and loss distribution have to be predicted because they are not available at the...

The situation of a limited availability of historical data is frequently encountered in portfolio risk estimation, especially in credit risk estimation. This makes it, for example, difficult to find temporal structures with statistical significance in the data on the single asset level. By...

Instruments for credit risk transfer arise endogenously from and interact with optimizing behavior of their users. This is particularly true with credit derivatives which are usually OTC contracts between banks as buyers and sellers of credit risk. Recent literature, however, does not account...

In the framework of the industrial economics approach to banking we extend the analysis of hedging against default on loans to the case of two types of credit risk. Standard results on the optimal hedge volume and the hedging effectivity from the single?risk case are shown to carry over to the...

Two shrinkage estimators for the global minimum variance portfolio that dominate the traditional estimator with respect to the out-of-sample variance of the portfolio return are derived. The presented results hold for any number of observations n = d 2 and number of assets d = 4. The...

This paper investigates the limit properties of mean-variance (mv) and arbitrage pricing (ap) trading strategies using a general dynamic factor model, as the number of assets diverge to infinity. It extends the results obtained in the literature for the exact pricing case to two other cases of...

The main challenge of forecasting credit default risk in loan portfolios is forecasting the default probabilities and the default correlations. We derive a Merton-style threshold-value model for the default probability which treats the asset value of a firm as unknown and uses a factor model...

Lending specialization on certain industry sectors can have opposing effects on monitoring (including screening) abilities and on the sectoral concentration risk of a credit portfolio. In this paper, we examine in the first part if monitoring abilities of German cooperative banks and savings...

We propose several connectedness measures built from pieces of variance decompositions, and we argue that they provide natural and insightful measures of connectedness among financial asset returns and volatilities. We also show that variance decompositions define weighted, directed networks, so...