IRC Calculation

YANNICK VAN DER STEL
THE INCREMENTAL RISK MODEL

An Assessment of Alternative Inputs and Assumptions
in a Multi-Period Setting
ii

AN ASSESSMENT OF ALTERNATIVE INPUTS AND ASSUMPTIONS IN A MULTI-PERIOD SETTING
ABSTRACT / EXECUTIVE SUMMARY

In the light of the current global financial crisis, the Basel Committee on Banking Supervision has released
a third proposal concerning the introduction of the incremental risk model and its resultant regulatory
capital charge. The purpose of this model is to capture the migration and default risk embedded in the
credit products in the trading book of financial institutions, as the recent episodes of financial turmoil
have proven banks to be undercapitalized, especially on those particular risks. Special attention is devoted
to the liquidity of the credit products in the model guidelines as well. Hence, the Incremental Risk Capital
Charge must provide banks with an additional capital buffer against migration and default risk as well as
liquidity risk in the trading book. In this study, a multi-period incremental risk model is derived in
accordance with the Basel Committees principles and requirements. The model structure is based on the
CreditMetrics model (i.e. Gupton et al., 1997), which is extended to a sequential multi-period setting. In
addition to the construction of the model, the principal inputs of the model, the credit migration matrix
and the issuer credit quality correlations, are estimated with the use of various alternative estimation
methodologies. The issuer asset correlation structure in the model displays both issuer correlation in the
cross-sectional dimension and autocorrelation in the time-series dimension. The issuer asset correlation
structure is modelled under the Gaussian copula assumption as well as two different t-Student copula
specifications. Subsequently, the eventual model is estimated with the use of three different corporate
bond portfolios. The resulting model estimations imply that the copula assumption (or tail dependence
specification) is the most vital input or assumption in the model, since the required one-year 99.9% VaRestimates are highly sensitive to this particular specification. This conclusion is almost certainly applies to
the incremental risk model in general as well. In addition, the assumed lengths of the liquidity horizons of
the assessed positions, the applied conditionality in credit migration matrix and the average level of issuer
asset correlations in the model are also highly likely to be crucial inputs or assumptions in the estimation
of the required risk measure in any incremental risk model. Lastly, the precision of the issuer correlations
in the model seems to be much less crucial than anticipated. The same applies to the choice in the
methodology utilized in the estimation of the credit migration matrix that is applied in the model.
AUTHOR:
Yannick van der Stel,
Intern at Ernst & Young Financial Services Risk Management (FSRM),
Master Student Financial Economics at Erasmus School of Economics (ESE),
Erasmus Universiteit Rotterdam (EUR).
ERNST & YOUNG
Financial Services Risk Management
ERASMUS UNIVERSITEIT ROTTERDAM
Erasmus School of Economics
Department of Finance
ERNST & YOUNG FSRM SUPERVISORS:
Boudewijn van Zijl, Manager
Gerd-Jan van Wiggen, Senior Manager
ERASMUS SCHOOL OF ECONOMICS SUPERVISOR:
Prof. Dr. Willem F.C. Verschoor, Chairman of the Department of Finance
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CONTENTS
PREFACE
INTRODUCTION
PART I: MODEL CONSTRUCTION
1.1
1.2
1.3
1.4
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Description of the Basel Committees Proposal

Starting Point
1.2.1
General Structure of the Incremental Risk Model
1.2.2
The CreditMetrics Model
The Multi-Period Simulation Model
1.3.1
Multi-Period Credit Rating Simulation
1.3.2
Valuation
1.3.3
Default Value
1.3.4
Model Output
The Correlation Structure
1.4.1
Objectives and Definitions in the Correlation Structure
1.4.2
Copulas
1.4.3
The First Copula: Issuer Correlations
1.4.4
The Second Copula: Autocorrelation
1.4.5
Effects of the Second Copula
1.4.6
Rebalancing Moments
PART II: INPUT ESTIMATION

2.1
Credit Migration Matrices

2.1.1
Standard & Poors Credit Ratings Data
2.1.2
The Cohort Method
2.1.3
The Duration Method
2.1.4
The Aalen-Johansen Estimator
2.1.5
Results and Comparison
2.1.6
Conditional Credit Migration Matrices
2.2 Issuer Correlation and Autocorrelation
2.2.1
Correlation
2.2.2
based on Default Rates
2.3 Corporate Bond Portfolios
2.3.1
Portfolio Construction
2.3.2
Liquidity horizons
PART III: MODEL ASSESSMENT

3.1
Model Estimation
3.1.1
Stand-Alone Risk
3.1.2
Correlations
3.1.3
Liquidity Horizons
3.1.4
Concentrated Positions
3.2 Interpretations, Extensions and Limitations
3.2.1
Crucial Inputs and Assumptions
3.2.2
The Scope of the Exercise
3.2.3
Stand-Alone Risk
3.2.4
Correlations
3.2.5
Constant Level of Risk Assumption
3.2.6
Additional Valuation Assumptions
3.2.7
The Position of the Incremental Risk Model within the Basel II Framework
CONCLUSIONS
APPENDICES
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Equity Return
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Asset Correlation
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A.1 The Two-Period Two-Issuer Correlation Correction

A.2 Default Correlation Estimates
A.3 Constituent Lists of the Corporate Bond Portfolios
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A.4 Credit Curves
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REFERENCES
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TABLES AND FIGURES

LIST OF TABLES
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VII
VIII
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XIII
Credit Migration Matrix: Cohort Method

Credit Migration Matrix: Duration Method
Credit Migration Matrix: Aalen-Johansen Estimator
Conditional Credit Migration Matrix: Duration Method
Implied Issuer Asset Correlations based on Observed Default Rates
Portfolio Details of the Long and Long-Short Corporate Bond Portfolios
Incremental Risk Model Estimates: Credit Migration Matrices
Incremental Risk Model Estimates: Issuer Asset Correlations
Incremental Risk Model Estimates: Autocorrelations
Incremental Risk Model Estimates: Liquidity Horizons
Incremental Risk Model Estimates: Concentrations
Default Correlations
Constituent Lists of the Corporate Bond Portfolios
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LIST OF FIGURES
I
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III
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V
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VII
VIII
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X
General Structure of the Incremental Risk Model

Asset Return Thresholds (Z-Values)
Recovery Rate Distribution
Portfolio Return Probability Distribution:
Credit Migration Matrix Comparison
Cumulative Portfolio Return Probability Distribution:
Credit Migration Matrix Comparison
Copula Assumption Comparison
Issuer Asset Correlation Comparison
Autocorrelation Comparison
Portfolio Return Probability Distribution:
Liquidity Horizon Assumption Comparison
Liquidity Horizon Assumption Comparison
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viii
PREFACE
This document is written as a Master Thesis Financial Economics for the Erasmus School of
Economics, during an internship at Ernst & Young FSRM in Amsterdam. Hence, I must
thank Ernst & Young FSRM Amsterdam, since they have provided me with the opportunity
to compose my Master Thesis in a corporate environment, which offered me a glimpse of the
actual practices in world of Finance. In particular, I wish to thank both of my Ernst & Young
FSRM supervisors, Gerd-Jan van Wiggen for useful conversations and his comments on
some particular topics that are addressed in the study and Boudewijn van Zijl for his
comments on the first draft version of this study.
I also wish to thank my Erasmus School of Economics supervisor, Prof. Dr. Willem F. C.
Verschoor, for the refereeing of the first draft version and the final version (this version) of
my Master Thesis. Moreover, I am pleased with the freedom that he has given me in both the
creation of my Thesis and in the format or structure of my Thesis.
Lastly, to avoid any confusion on the subject, I must note that even though I had three
supervisors in the process, the complete content of this study, as well as its layout, is a
product of my own mind. In this context, the source of all errors it may still contain is
naturally revealed as well.
CreditMetrics: The central topic in this study is the Incremental Risk Capital Charge and the
incremental risk model on which this regulatory capital charge is based. The Incremental Risk
Capital Charge has been in the consultative trajectory since June 2007 and is additional capital
charge in the Basel II Market Risk Framework that must provide a capital buffer against the
default and migration incremental to the credit positions in a banks trading book. Hence, an
incremental risk model must address default and migration risk in the trading book. For this
particular purpose, the CreditMetrics model (Gupton et al., 1997) is utilized as a basis on
which the incremental risk model that is proposed in the study is built. Although the
CreditMetrics model on itself is discussed in the study, it is essential to note that it is assumed
that the reader is to some degree familiar with the model. More importantly, the assumption
is made that the reader is familiar with its intuition.
Finalized incremental risk model guidelines: The last important note to the reader is that this
study, and therefore the incremental risk model that is proposed in this study, are based on
the incremental risk model guidelines that were released in January 2009 by the Basel
Committee on Banking Supervision (BCBS, 2009a). This particular document is of
consultative nature, which indicates that the guidelines that it contains were not finalized yet
at that point in time. Nonetheless, in July 2009 during the creation of this studys content, the
Basel Committee of Banking Supervision has released the finalized version on the
incremental risk model guidelines: Guidelines for Computing Capital for Incremental Risk in the
Trading Book (BCBS, 2009d). I am especially pleased to inform you that none of the essential
aspects in the consultative paper of January 2009 have been changed in the final version of
the incremental risk model guidelines of July 2009. Consequently, the findings and
conclusions that are presented in this study apply to the finalized guidelines of incremental
risk model as well.
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INTRODUCTION
midst the global financial crisis that originated during 2007, the Basel II banking capital standard has
been proclaimed to be among the many causes. Ever since the appearance of its first consultative paper
in June 1999, the Basel II standard has been evolving, yet this not so subtle point easily becomes lost in the
debate. Even so, the Basel Committee on Banking Supervision (the Basel Committee) has identified many of
the shortcomings in the regulatory framework and has undertaken swift actions to address them. One such
step is the recent publication of a package of consultative papers that set forth amendments and additions to
the Basel II Market Risk Framework (BCBS, 2009a, 2009b).
Although not yet finalized, the new regulation addresses many critical shortcomings of the current Market
Risk Framework. In the Basel II Framework, banks are required to make a separation between assets held in
the trading book and assets held in the banking book. The minimum regulatory capital required for trading
book positions are predominantly computed using value-at-risk measures, and require much lower capital
weights than banking book positions. The Basel Committee recognized that since the financial crisis began in
the middle of 2007, the majority of losses and build up of leverage occurred in the trading book (BCBS,
2009a). Moreover, trading book losses were substantially higher than the minimum capital requirements.
Herein, multiple contributing factors can be identified. First of all, the applied value-at-risk models
underestimated risk since they were based on a benign period in financial markets. In addition, some key risks
were not adequately captured in the value-at-risk models. The most imperative types of unaddressed risk being
the default and migration risk imbedded in credit positions in the trading book. In the spectrum of US
corporations that are rated by Standard & Poors, for example, the number of AAA-rated issuers has declined
by 40% during the crisis. Moreover, the number of CCC/C-rated issuers has increased with a staggering 140%
and roughly 75% of all defaults of S&P-rated issuers since the start of 2005 have occurred in the last two
years.1 A third large problem, as clarified by Parsons (2009), has been that many banks were holding assets in
the trading book to benefit from the lower regulatory capital requirements, compared to the banking book.
Hence, large differences between the capital required for trading book positions and banking book positions
led to an undesired form of regulatory capital arbitrage. In essence, one of the main causes of the high level
of unrecognized leverage, from a capital adequacy perspective, in the trading books of many banks is
identified here as well.2 Banks simply held super senior and AAA-tranches of securitized assets in the trading
book, as being held for trade or sale, to ensure they could be placed in the trading book. In practice, however,
large inventories were accumulated that were subject to low capital requirements, resulting in a relative large
the return on capital. When circumstances started to deteriorate, not only losses were generated on these
extremely leveraged positions, but also capital requirements to support them increased.
Complementary to the shortcomings that were identified in the Market Risk Framework, the importance of
adequately capturing liquidity risk has been severely amplified by the recent episodes of global financial
turmoil as well. Consequently, liquidity risk has become of significant importance in the Basel Committees
agenda. Throughout the crisis liquidity risks have been prominent, as numerous banks suffered from
asset/liability mismatches, since they held inadequate cash and liquid assets while wholesale funding sources
and even the interbank market dried up (Parsons, 2009). The most obvious example here is the nationalization
of Northern Rock in the United Kingdom. One of the weaknesses of the current Basel II Market Risk
Framework therefore is that it hardly touches the subject of liquidity in the trading book.
On January 16, 2009, the Basel Committee released the consultative paper Revisions to the Basel II Market Risk
Framework (BCBS, 2009b) that proposes amendments to the current framework in order to address the issues
The CCC/C rating class contains issuers that are rated CCC, CC or C. Furthermore, the presented percentages are all based on the
total spectrum of US corporations rated by Standard & Poors as indicated by the Rating Changes data that can be obtained in
Bloomberg Professional. The total number of rated issuers in this spectrum declined slightly during the crisis (by roughly 6%).
Risk adjusted measures of leverage, such as value-at-risk relative to equity or risk-weighted assets divided by tier 1 capital, did not
recognize the substantial increase in leverage (FSA, 2009).
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INTRODUCTION
and weaknesses explained above. Banks expect these new capital rules to raise the minimum capital required
to support trading book positions by up to three times (Parsons, 2009). In the market risk capital regime set
forth by the current proposal, the traditional ten-day 99% VaR has been preserved, as it is only subject to
minor changes. In addition to the traditional VaR-measure, a ten-day 99% stressed VaR is introduced, which
is approximately equivalent to the traditional ten-day 99% VaR conditioned to a year of economic turmoil
(BCBS, 2009b). The stressed VaR has to ensure that the market risk capital requirements are not completely
based on benign market conditions at such periods. In addition, it should also reduce the undesired procyclicality in the market risk capital requirements under the current framework.3 Furthermore, to address the
recognized problems within structured credit markets that lay at the core of the crisis, relatively high
mandatory standardized specific risk charges for positions of a securitized nature have been introduced in the
trading book capital regime.4
The remainder of the credit risk embedded in trading book positions, in the form of default and migration
risk, is to be captured by the newly proposed Incremental Risk Capital Charge, which can be considered one
of the main regulatory responses to the credit crisis. This charge was formerly proposed as the incremental
default risk charge (BCBS, 2007). Later the scope was expanded to also include migration risk, since it was
recognized that the majority of the losses, not captured by the traditional market risk VaR, had not arisen
from actual defaults but rather from credit migrations in combination with the widening of credit spreads
(BCBS, 2008a). In the guidelines of the model underlying the Incremental Risk Capital Charge, particular
attention is directed towards liquidity risk as well.5 In addition, one of the most profound reasons behind the
introduction of the charge is the prevention of regulatory capital arbitrage. Although not finalized, the new
regulation represent an important step to closing a gap in the existing capital rules credit risk in trading
portfolios that has been severely exposed by recent events (Finger, 2009).
The third consecutive paper on the incremental risk charge, released in January 2009, was titled: Guidelines for
Computing Capital for Incremental Risk in the Trading Book (BCBS, 2009a). This consultative document lays down
the principles and requirements of the incremental risk model underlying the Incremental Risk Capital Charge.
The particular liquidity risk related specification requirements within this model ensure that completely new
migration/default risk models have to be developed. Hence, the derivation of such a model is exactly what
will be the main objective of this study.
In the credit risk related literature, obvious examples of practical approaches to modelling migration and
default risk in the portfolio context are RiskMetrics Groups CreditMetrics model (Gupton et al., 1997), Credit
Suisse Financial Products CreditRisk+ model (Wilde, 1997), Moodys KMVs KMV-model6 (Bohn & Crosbie,
2003) and McKinseys CreditPortfolioView (Wilson, 1997). These models describe default and migration risk
in theoretically appealing and practical ways. Nevertheless, none of them allows for simple adjustments to
enable the incorporation of the incremental risk model requirements, as set forth by the Basel Committees
model guidelines. In fact, not yet any literature exists about the modelling of the incremental risk model. The
literature on the regulatory Basel II Framework mainly focuses on subjects such as the information content of
the traditional market risk VaR disclosures or Basel capital ratios and VaR modelling approaches.7 The market
risk VaR has been in existence for a relatively long period of time and therefore it has made numerous
3
4
5
6
Pro-cyclicality in capital requirements describes the cyclical character of the Basel II capital requirements. It implies that when
markets are benign the capital requirements are low and that capital requirements are high when markets reach bottom of the cycle.
The danger of pro-cyclicality in regulatory capital requirements is that it can accentuate the economic cycle.
In a more general consultative document, also released in January 2009, that is titled: Proposed Enhancements to the Basel II Framework
(BCBS, 2009c) more general attention is paid to changes in the assessment of securitizations and re-securitizations.
Liquidity problems were one of the first symptoms of the crisis and were also addressed in an earlier BIS/BCBS publication titled:
Principles for Sound Liquidity Risk Management and Supervision (BCBS, 2008b).
The KMV-model actually describes the credit risk of individual issuers in terms of expected default frequencies (EDF). Moodys
KMV has developed the KMV Portfolio Manager to assess credit risk in the portfolio context. The basic structure of this model is
described in Kealhofer & Bohn (2001), yet the model is not publicly disclosed in a way comparable to the CreditMetrics model or
CreditRisk+ model.
For example, Jorion (2001, 2002), Liu et al. (2004) and Lim & Tan (2007).
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ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS
appearances in the literature. In contrast, the incremental risk model specifications have not even be finalized
yet. Consequently, no literature on the current version of the incremental risk model proposal exists. Two
studies, Dunn et al. (2006) and Dunn (2008), do exist in which an incremental default risk model is developed
and assessed, according to the set of rules that was proposed by the Basel Committee in the first consultative
paper on the subject. Nonetheless, since crucial aspects have been changed in the two consecutive
consultative documents, a comparison between the results of these studies and those that will be produced in
this study is meaningless.
In the derivation of the incremental risk model in this study, the CreditMetrics model is used as a starting
point. The Basel Committees incremental risk model guidelines specify a setting in which a multi-period
model is the most appropriate model structure. The CreditMetrics framework will therefore be modified and
extended to a multi-period setting to display the Basel Committees modelling requirements. Besides the
model itself, the inputs that are required in such a model will also be estimated, applying various common
approaches or techniques from the relevant literature. Multiple aspects of the credit risk related literature are
therefore evaluated and applied in the proposed model. The initial objective of the study is to construct an
incremental risk model according to the Basel Committees standards, albeit in a somewhat stylized setting. A
more important objective is, however, that numerous alternative supplementary inputs and assumptions will
be employed in this model. Such an application ensures that a detailed assessment can be made on the
importance of the required inputs and assumptions in the model.8 Moreover, an attempt is made to compose
such an assessment in a setting in which most of the model specific conclusions, with respect to the
importance of the inputs and assumptions, can be extended to the incremental risk model in general.
The implications of this assessment are quite obvious in the regulatory, modelling and model validation
context. First of all, since publicly available information on the incremental risk model is severely limited, any
information presented in this study is relevant for anyone who has any interest in the incremental risk model.
More specifically, this study may have regulatory implications, as regulators can to some extent identify
whether the initial objectives behind the model are likely to be reached, based on the results of this study.
Moreover, model development implications are obvious, as not only a somewhat stylized incremental risk
model will be developed, but also numerous ideas with respect to the improvement of the constructed model
or an incremental risk model in general are proposed. Lastly, in the validation context, the results of this study
will shed light on the importance of the assumptions and inputs in the incremental risk model. As with any
new model, the validation standard is still to be developed to some extent and is therefore still evolving. The
identification of the most imperative inputs and assumptions, in the estimation of the required risk measure, is
crucial in the development of such a validation standard. In essence, the information presented in this study
may show model validators on which model aspects emphasis must be placed in the validation process of an
actual incremental risk model.
The study is organized in three parts. In Part I, the requirements and principles of the model will be discussed
and the complete model will be derived in terms of a simulation model and a correlation structure. In Part II,
the required inputs in the derived model are estimated with the use of alternative methodologies. In addition,
three portfolios are built that allow for the estimation of the proposed model and assessment of the effects of
its inputs and assumptions. The last part, Part III, will contain this assessment of the model and its inputs and
assumptions. Basically, the model will be estimated with the use various alternative inputs under multiple
alternative assumptions. The interpretations of these estimations are presented here as well. Moreover, all
components of the model are discussed once again and possible limitations and model improvements are
highlighted in this assessment. Lastly, the conclusions will provide a summary of all relevant aspects that are
The objective of this assessment is similar to that of the assessment of the incremental default risk model in Dunn et al. (2006) and
Dunn (2008), yet its execution is much more comprehensive in nature.
ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT
13
INTRODUCTION
discussed in the study. Herein, the eventual implications of the proposed incremental risk model and its model
estimation are a central topic as well.
14
PART I
MODEL CONSTRUCTION
1.1
DESCRIPTION OF THE BASEL COMMITTEES PROPOSAL
In Part I of this study, first, a detailed

description is presented of the guidelines and
principles that provide the regulatory basis of the
incremental risk model, as set forth by the Basel
Committee. Naturally, an assessment of the
underlying principles and guidelines is
appropriate in the construction of such a model.
Taking the guidelines into consideration, section
1.2 specifies the required starting point for the
construction of the incremental risk model that is
proposed in this study. This starting point
comprises a general structure that is based on the
guidelines and a technical approach, which is the
CreditMetrics model as stated in the
introduction. The actual incremental risk model
is constructed in section 1.3. Herein, a credit
rating simulation model and a valuation model
are derived, which together form the simulation
model. Essentially, the CreditMetrics singleperiod setting is extended to a multiple period
model that accounts for the Basel Committees
technical requirements, in the form of
rebalancing opportunities to maintain a constant
level of risk throughout the pre-specified risk
horizon. In the last section of Part I of the
study, section 1.4, a structure is derived that
addresses the interactions between the migration
and default risks embedded in the individual
positions in the model. It encompasses the
correlations between the credit quality levels of
the issuers, underlying the assessed credit
positions in the trading book, as well as the
autocorrelations for individual issuers. This
correlation structure is obviously complementary
to the model derived in section 1.3.
In the construction of an incremental risk model that is in accordance with the Basel Committees standards,
first, the most recent incremental risk charge proposal, as released by the Basel Committee, must be examined.
Accordingly, this section will provide an overview of the most relevant aspects, in the context of this study, as
presented in Guidelines for Computing Capital for Incremental Risk in the Trading Book: Consultative Document (BCBS,
2009a). The guidelines presented in this document set forth the requirements and principles to which an actual
incremental risk model must comply.9
The incremental risk model must capture the migration and default risk incremental to the positions in the
trading book of a bank. The Incremental Risk Capital Charge encompasses all positions subject to the capital
charge for specific interest rate risk according to the internal models approach to specific market risk,
regardless of their perceived liquidity. However, securitization and re-securitization exposures are not
considered by the Incremental Risk Capital Charge. Basically, all unsecuritized credit products in the trading
book are covered by the Incremental Risk Capital Charge, whereas all securitization and re-securitization
exposures are covered by prescribed standardized specific risk capital charges.
One of the objectives of the proposed Incremental Risk Capital Charge is to achieve consistency between
capital charges for similar positions in the trading book and the banking book, though adjusted for illiquidity.
Therefore the soundness standard or confidence interval is 99.9% with a one-year capital horizon. More
specifically, the incremental risk model should measure default and migration risk at the 99.9% confidence
interval over a capital horizon of one year, taking into account the liquidity horizons for the individual trading
positions or sets of positions (one-year 99.9% value-at-risk).10 Losses caused by larger market-wide events
affecting more issues/issuers are also captured by this definition. The incremental risk model should also
capture the impact of rebalancing the positions at the end of their liquidity horizons in a way to achieve a
constant risk level over a one-year horizon.
The relatively long length of the capital horizon and the high soundness standard are consistent with the
going concern principle that is pursued by the Basel Committee. The aim of regulatory capital requirements
according to this principle is that banks can withstand losses, and are able to continue their normal activities
without the need to raise additional capital. Such a principle is warranted as recent events have demonstrated
that banks are not likely to be able to raise additional capital during periods of severe economic turbulence.
Moreover, the one-year 99.9% soundness standard is in accordance with the standard that is applied in the
banking book (the internal ratings-based model).
Stressed credit market events have shown that banks cannot assume that market remain liquid under those
conditions. Banks experienced significant illiquidity in a wide range of credit products held in the trading
book. Banks should therefore pay particular attention to the appropriate liquidity horizon assumption in their
incremental risk model. For this purpose, the Basel Committee introduces the concept of the liquidity
horizon. The liquidity horizon represents the time required to sell the position or to hedge all material risks
covered by the incremental risk model in stressed market conditions.
The floor of the liquidity horizon is set to three months. Furthermore, within a given product type a noninvestment grade position is expected to have a longer assumed liquidity horizon than an investment grade
position. Conservative assumptions regarding non-investment grade positions are warranted, until further
evidence is gained regarding the markets liquidity in period of systematic and idiosyncratic stress. Banks
should also use conservative assumptions, regardless of the credit rating, for positions where the secondary
market liquidity is not deep, during periods of financial market volatility and investor aversion. The application
of prudent liquidity assumptions is particularly important for rapidly growing product classes that have not yet
been tested in a downturn.
9
10
Most of the content in this section is directly taken from the original BIS/BCBS document: BCBS (2009a).
The applied Incremental Risk Capital Charge at a specific point in time is calculated by taking the maximum of the most recent
incremental risk measure and the average of the incremental risk measure over the most recent 12 weeks.
16
The liquidity horizon is expected to be higher for positions that are concentrated, reflecting the longer period
that is required to liquidate such positions. This is necessary to provide adequate capital against two types of
concentration: issuer concentration and market concentration. A concentrated portfolio should attract a
higher capital charge than a more granular portfolio. Concentrations that can arise within and across product
classes under stressed conditions must also be reflected.
In the application of the liquidity horizon, an incremental risk model must incorporate a constant level of risk
assumption of the capital horizon. The constant risk level implies that a bank rebalances or rolls over its
trading positions over the one-year capital horizon in a way that preserves the risk level, as indicated by a
metric such as value-at-risk or the profile of the exposure by credit rating and concentration. This implies that
positions with credit characteristics that have deteriorated or improved should be replaced in the process by
positions with the initial risk level at the start of the liquidity horizon. Moreover, the rebalancing process
should mainly be dependent on the liquidity horizon of the position. In summary, the incremental risk model
must be configured such that the positions are rebalanced to their initial risk level at the end of their liquidity
horizons.
In addition, correlations between default and migration events should be incorporated in the incremental risk
model, as financial and economic dependence amongst obligors tends to generate clusters of default and
migration events during economic recessions (i.e. the bottom of the business or credit cycle). Consequently,
the Incremental Risk Capital Charge must include the impact of correlations between default and migration
events amongst obligors.
Furthermore, the Basel Committee argues that the impact of diversification between default and migration
risks in the trading book and other risks in the trading books is currently not well understood and should
therefore not be captured by the incremental risk model. This is consistent with the Basel II Framework,
which does not allow for diversification benefits when capital requirements regarding market risk and credit
risk are combined. Accordingly, the capital charge for incremental risk is added to the value-at-risk-based
capital charge for market risk.
In the model validation context, the validation principles in the Basel II Framework, regarding designing,
maintaining and testing the model, should be applied. This includes evaluating conceptual soundness, ongoing
monitoring that includes process verification and benchmarking, and outcome analysis.
Liquidity horizons should reflect actual practice and experience during periods of both systematic and
idiosyncratic stress. The model that measures default and migration risks should take objective data into
account over the relevant horizon and should include a comparison of risks estimated for a rebalanced
portfolio with that of one with fixed positions.
Correlation assumptions must be supported by analysis of objective data. In a multi-period model, the bank
should evaluate the implied correlations to ensure that they are reasonably in line with observed annual
correlations. It has to be validated that the modelling approach for correlations is appropriate for the banks
portfolio.
Backtesting regarding the 99.9% one-year soundness standard is not possible. Consequently, validation of the
incremental risk model must rely more heavily on indirect methods including but not limited to stress tests,
sensitivity analysis and scenario analysis, to assess its qualitative and quantitative reasonableness (particularly
with regard to the models treatment of concentrations). Such tests should not be limited to a range of
historical events.
The validation of a model represents an ongoing process in which supervisors and banks jointly determine the
exact set of validation procedures to be employed. Banks should develop relevant internal modelling
benchmarks to assess the overall accuracy of their incremental risk models.
1.2
STARTING POINT
17
The guidelines and requirements presented in the previous section form a general regulatory setting on which
the incremental risk model must be built. In the modelling process, the first step is to construct a general
model structure of the components and the links between these individual components within the incremental
risk model. Subsequently, a technical credit risk model is required to form a technical starting point that can be
modified in order to incorporate this general model structure (in terms of the migration risk, default risk and
liquidity risk according to the guidelines and principles as defined in the Basel Committees proposal).
1.2.1 General Structure of the Incremental Risk Model
Figure I (on the next page) incorporates the most imperative model requirements into the general model
structure. It displays the likely relations between the components, generating the shape that the incremental
risk model should take on. In essence, all unsecuritized credit products in the trading book of the bank (the
portfolio) must be assessed in the model. All these positions have individual characteristics: the exposure, the
migration and default probabilities, the expected losses on the positions due to default or due to migration and
lastly, the liquidity horizon of the position. Together, these characteristics generate the primary description of
the counterparty migration and default risk of the individual positions in a way that is consistent with the
specifications prescribed by the Basel Committee. The second important aspect that a model of this kind
should comprise is the interaction between those individual risks. These relations must to be modelled, using
the correlations between the credit quality levels of the underlying issuers, to address the default and migration
risk incremental to the entire portfolio. Moreover, the correlations between the issuers can produce issuer
concentrations or market concentrations, which in their turn must be reflected in the liquidity horizons of
these respective positions.
Subsequently, in the derivation of the eventual Incremental Risk Capital Charge, the constant level of risk
assumption must be taken into account. In essence, the Incremental Risk Capital Charge is nothing more than
a one-year 99.9% value-at-risk measure. This constant level of risk assumption sets forth the requirements that
the underlying model must meet in order to combine the consecutive liquidity horizons of all positions in the
portfolio into the single capital horizon of one year. The structure that is required to achieve this should
depend mainly on the liquidity horizons of the positions in the model, since they must be the driving factors
behind effects of the constant level of risk assumption. Obviously, the assumption affects the way issuer
correlations are modelled, although this aspect is a practical or technical issue.
Besides this general structure, a technical approach is required, as there are many viable approaches in the
subject of portfolio credit risk.11 The model handles the two key credit risk aspects, default and migration risk,
and therefore the eventual portfolio value distribution is expected to be highly asymmetric and is not likely to
be assessable with a distribution assumption of any kind. Consequently, simulation is the only feasible
approach in the estimation of an eventual portfolio value distribution.
The first well known application of the portfolio credit risk subject in this form is provided in the almost
classical Technical Document of CreditMetrics (Gupton et al., 1997). The approach presented in this document is
straightforward and is intuitively appealing. One could argue that it marked the start of modelling credit and
migration risk in a portfolio setting in a general portfolio form. The incremental risk model that is constructed
in this study will be a modified or extended version of this particular credit risk model. Basically, the
CreditMetrics model is tailored to fit the Basel Committee guidelines. In this process, the original idea and
intuition behind the model will be preserved to a great extent.
FIGURE I - General Structure of the Incremental Risk Model
11
The best known practical approaches are RiskMetrics Groups CreditMetrics model (Gupton et al., 1997), Credit Suisse Financial
Products CreditRisk+ model (Wilde, 1997), Moodys KMVs Portfolio Manager and McKinseys CreditPortfolioView (Wilson,
1997). A comparison of these credit risk models is provided by Crouhy et al. (2000), Gordy (2000) and Nyfeler (2000). Moreover,
Saunders & Allen (2002) provide detailed information on the workings of all mentioned models as well.
18
Default probabilities
Loss due to default
All unsecuritized
credit products in
the trading book
Migration probabilities
Loss due to migration
Exposures
Default risk
Liquidity horizons
Migration risk
Issuer and market

concentrations
Default and migration
risk correlations between
multiple issuers
Constant level of risk assumption

Default and migration risk at the 99.9% confidence
interval over a capital horizon of one year
Incremental Risk Capital Charge
Default risk and migration default may be combined in the model instead of the separation that is displayed above.
1.2.2 The CreditMetrics Model

To utilize the CreditMetrics model as a technical starting point, first, an assessment of the CreditMetrics
model is required. The model starts off with the specification of the stand-alone default and migration risk
embedded in the credit products in the portfolio. This risk is presented in the form of a credit migration
matrix. The credit migration matrix is an 8 x 8 matrix that contains the probabilities of any issuer, underlying
the relevant credit product, to travel from a given initial credit rating to any other credit rating (including
default and its initial credit rating) in a preset time horizon.12 Tables I, II and III on page 47 and 48 in Part II
section 2.1.5 are examples of credit migration matrices. Such a matrix of migration probabilities provides the
information that is required to simulate the credit ratings of the underlying issuers at the end of the horizon.
The simulation of those credit ratings underlying the positions in the assessed portfolio is where the second
important component of modelling any sort of risk on the portfolio level is integrated, namely the interactions
between the stand-alone risks of the different positions in the portfolio.
The Basel Committee states that the migration and default events amongst issuers tend to cluster. This claim
is confirmed by a large body of literature on the default and migration correlation. The number of studies on
default correlation has been growing rapidly since well known studies such as Lucas (1995) and Gupton et al.
(1997), i.e. the Technical Document of CreditMetrics, have appeared. The existence of correlation amongst
issuers in their level of creditworthiness (or asset values) has more or less become a stylized fact in financial
economics and is easily explained by the fact that large groups of issuers are affected by the same economic
12
The matrix contains eight credit rating classes: AAA, AA, A, BBB, BB, B, CCC/C and Default. Credit rating modifiers (+) and (-)
are ignored. The motivation behind this modification is presented in Part II section 2.1.1. Moreover, in Part II section 2.1, credit
migration matrix estimation methodologies are discussed and applied.
19
(risk) factors. The more similarities these issuers share, the larger the likelihood that when one issuers asset
value degenerates, the same will happen to others. Then when one considers a portfolio of credit products
with multiple underlying issuers, these correlations ensure that the chance of a deterioration of credit quality
of multiple issuers at the same time is larger than implied by credit migration matrices. Hence, issuer
correlations generate an extra source of risk in a credit portfolio.
CreditMetrics accounts for this issue by applying the intuition of the Merton model (Merton, 1974). This well
known model simply states that a company defaults when the value of its assets drops below the value of its
debt. Furthermore, since the credit quality of an issuer signals the likelihood of non-payment of its debt
obligations, the credit rating of a company or issuer should reflect likelihood of the value of the assets
dropping below the value of the companys debt. Hence, there is a direct theoretical link between the issuers
asset value (and asset returns) and its credit quality. More specifically, the dynamics of the asset returns of
issuers and the relations between the asset returns of multiple issuers should capture the credit quality
correlations between the issuers. Essentially, when the actual correlation between the asset returns of two
issuers is known, the migration and default correlations between these issuers can be described.
Gupton et al. (1997) implement the asset correlation concept in their CreditMetrics simulation framework.
First, employing the credit migration matrix, asset return thresholds are specified with respect to issuer assets
returns ( R ) for each possible migration event (or probability) given each initial credit rating. In this context,
issuer asset returns are assumed to be normally distributed. The thresholds (Z-values) are found by fitting the
migration probabilities under the cumulative standard normal distribution function. For example, for BBBrated issuers the asset return thresholds derived as follows:
P( BBB D) P( R Z BBBD ) (Z BBBD ) ,
(1.1)
P( BBB CCC / C) P(Z BBBD R Z BBBCCC/C ) (Z BBBCCC/C ) (Z BBBD ) ,
(1.2)
P( BBB B) P(Z BBBCCC/C R Z BBBB ) (Z BBBB ) (Z BBBCCC/C ) ,
(1.3)
P( BBB BB) P(Z BBBB R Z BBBBB ) (Z BBBBB ) (Z BBBB ) ,
(1.4)
P( BBB BBB) P(Z BBBBB R Z BBBBBB ) (Z BBBBBB ) (Z BBBBB ) ,
(1.5)
P( BBB A) P(Z BBBBBB R Z BBBA ) (Z BBBA ) (Z BBBBBB ) ,
(1.6)
P( BBB AA) P(Z BBBA R Z BBBAA ) (Z BBBAA ) (Z BBBA ) ,
(1.7)
where the cumulative univariate standard normal distribution function is denoted by (.) .
FIGURE II - Asset Return Thresholds (Z-Values)
Figure II displays the thresholds in
graphical form. The Z BBBD threshold
value ( Z D in the figure), for example,
specifies that a simulated issuer asset
return of a BBB-rated issuer below that
particular value produces a simulated
default of that BBB-rated issuer at the
end of the considered horizon. Note that
no threshold concerning the migration to
the AAA-rating is specified, as an asset
ZD ZCCC/C ZB ZBB
0
ZBBB ZA ZAA
return higher than ZCR AA always implies
The asset return thresholds specify the simulated credit rating at the end of the risk
a transition to the AAA-rating. For each
horizon, based on the simulated issuer asset return. The displayed example concerns
credit rating ( CRt ), except the default
an issuer with BBB initial credit rating. Moreover, the assumed asset return
distribution is Gaussian.
rating, the seven Z-values are computed.
Consequently, when an asset return is
simulated for each issuer in the portfolio, the credit rating for each issuer at the end of the considered (risk)
t
20
horizon can be obtained, conditional to its initial credit rating. A simulated issuer asset return in this
framework is a standard normally distributed random variable. The generation of the credit rating ( CRtk ,i ) at
the end of considered risk horizon ( k ), using the initial credit rating ( CRt ,i ) and the simulated issuer asset
return ( xi ) underlying the credit position i , is expressed as follows:
CRt k ,i
D
CCC / C
BB
BBB
A
AA
AAA
if xi Z CR D
t
if Z CR D xi Z CR CCC /C
if Z CR CCC /C xi Z CR B
t
if Z CR B xi Z CR BB
,
if Z CR BB xi Z CR BBB
if Z CR BBB xi Z CR A
t
(1.8)
if Z CR A xi Z CR AA
if Z CR AA xi
t
where xi ~ N(0,1) .
The issuer asset correlations are incorporated by generating random drawings from the standard normal
distribution that are correlated according to the actual asset correlations between the issuers. Consequently,
the simulated credit migrations are correlated. The only remaining step is the calculation of the value of each
position at the end of the horizon, given the simulated credit rating. The sum of these values is the total
portfolio value at the end of the considered risk horizon for one particular simulation scenario of issuer asset
returns. The total portfolio value distribution is produced by generating a large number of correlated asset
return scenarios and obtaining their resulting total portfolio values. The required value-at-risk measure can
simply be taken from this distribution.
The CreditMetrics model provides a powerful and intuitively appealing simulation framework. Notice that the
assumption that the issuer asset returns are normally distributed does not actually imply that these returns
must be normally distributed in reality. The assumption essentially states that the nature of the issuer asset
correlations is Gaussian (normal), which obviously is a less strict assumption than the assumption that asset
returns are actually normally distributed.
The CreditMetrics model serves as an excellent starting point in the derivation of an incremental risk model. It
incorporates the majority of the Basel Committees requirements directly, though there is an essential aspect it
cannot handle. Namely, the CreditMetrics model incorporates a single risk horizon that is equal for all
positions in the evaluated portfolio. Moreover, the model does not allow for rebalancing of positions before
the end of that single uniform risk horizon. In such a structure, the effects of the constant level of risk
assumption and the concept of the liquidity horizon (that may differ for all positions in the portfolio), clearly
cannot be accurately captured or implemented. The main complication lies within single-period nature of the
technical correlation structure of the CreditMetrics model. Essentially, a multi-period model is warranted to
handle the possible variety of different liquidity horizons of the positions in a banks trading book.
1.3
THE MULTI-PERIOD SIMULATION MODEL

The primary objective of the multi-period model is the incorporation of the constant risk assumption into the
simulation model. In other words, a method must be devised that ensures that the complete horizon
considered by the model (i.e. the capital horizon of one year) can be divided into liquidity horizons for
different positions, allowing for rebalancing to the initial risk of the position at the end of each liquidity
horizon. Therefore, the specification of the multi-period model should depend mainly on the length of
liquidity horizons of the credit products in the portfolio. Furthermore, the initial risk level is defined as a
position of the same class and size as the original position, with the same credit rating as the initial credit
21
rating underlying the position and with an underlying issuer with similar issuer correlations as the original
exposure. This definition of the initial risk level is consistent with the Basel Committees guidelines.
The idea behind the multi-period setting is that rebalancing possibilities are generated at the end of every
period. In such a model, not only the credit ratings underlying the positions at the end of the capital horizon
are simulated, but also the credit ratings at the end of every single-period in the model before the end of the
capital horizon. The credit rating, on which the simulated rating at the end of each single-period is based, is
either the credit rating at the end of previous single-period if no rebalancing occurs, or the initial credit rating
of the original issuer underlying the position if the position is rebalanced to its initial risk level.
The constant risk assumption basically implies that rebalancing occurs at the end of every liquidity horizon or
when the simulated credit rating of the issuer at the end of the period signals a default. The latter actually
implies that a single position can account for multiple defaults within one liquidity horizon and within the
capital horizon.13 As a consequence, the loss on a single position in the complete capital horizon can be larger
than its loss given default. Furthermore, when a position is rebalanced, the underlying issuer effectively
changes, as the original issuer has been either upgraded or downgraded and does not match the initial risk
level anymore. Nevertheless, since it is assumed that the new issuer has the equivalent risk characteristics
compared to the original issuer, the issuer asset correlations of the original issuer are applied to specify the risk
characteristics of the new issuer, in combination with the initial credit rating of the original issuer. The new
position after rebalancing to the initial risk level is therefore purely hypothetical.
In this study, a four-period model is derived. Hence, the model contains four three-month periods that
together constitute the capital horizon of one year. The liquidity horizon of a credit product may therefore be
set to three, six, nine or twelve months. At the end of each single-period one must determine whether each
position should be rebalanced or not (e.g. a position with a liquidity horizon of nine months may not be
rebalanced to its initial risk at the end of the first period of three months, but will be rebalanced at the end of
the third period, which is the end of its liquidity horizon). In practice, a better specification is twelve onemonth periods or even more and shorter periods, since a more detailed specification of liquidity horizon
lengths is possible in a model with a larger number of periods. Even so, in this study a four-period model is
considered, since it is more convenient in a practical sense and still allows for an extensive examination of the
model and the effects of its underlying assumptions and inputs.
In the four-period model, each position has four underlying simulated three-month issuer asset returns.
Similar to the CreditMetrics model, these simulated issuer asset returns are random correlated drawings from a
pre-specified distribution. The construction of such a correlated issuer asset return structure will be discussed
in section 1.4. In the remainder of the current section, the model is constructed that converts these correlated
simulated single-period issuer asset returns into the required simulated credit ratings. In addition, a
complementary valuation model will be created, in which these simulated credit ratings for each position at the
end of each of the four periods are converted to the portfolio value at the end of the capital horizon. The
simulation model basically becomes a sequence of four CreditMetrics credit rating simulation models.
1.3.1 Multi-Period Credit Rating Simulation
In the credit rating simulation model, first of all, the stand-alone risk specification for all single positions has
to be defined. Like the CreditMetrics model, credit migration matrices and their corresponding asset return
thresholds (Z-values) are used for this purpose. The only difference is that the credit migration matrix has to
be calibrated to a horizon of three months, as the credit rating underlying each product is simulated three
months ahead in each single-period. The estimation of credit migration matrices will be discussed in Part II
section 2.1. For now, it suffices to assume that all Z-values for all initial rating classes are known.
13
Another interpretation of the constant level of risk assumption is that a position can only default once in a single liquidity horizon.
Nevertheless, this alternative interpretation implies that if a position defaults before the end of its liquidity horizon, there is no risk
at all in the remainder of that liquidity horizon, since no new position is taken on after the default has occurred.
22
Subsequently, the simulated three-month asset returns of the issuers underlying each credit product ( i ) are
required, for all four single-periods of the model:
xt 3,i , xt 6,i , xt 9,i and xt 12,i for i 1,..., n ,
where n is the number of credit positions in the portfolio ( t is in months).

All four simulated issuer asset returns for each position are random drawings from the standard normal
distribution and therefore: xtk ,i ~ N(0,1) for k 3,6,9,12 and i 1,..., n ( k specifies the end of each singleperiod and is in denoted in months). The additional portfolio induced correlation risk is incorporated through
issuer asset correlations and autocorrelations. Hence, the simulated issuer asset returns of all positions are
correlated according to an estimated or observed issuer correlation matrix and the simulated issuer asset
returns are auto-correlated in subsequent single-periods per issuer according to estimated or observed issuer
asset autocorrelations. The methodology underlying this double correlation structure is addressed in section
1.4. Again, for now it suffices to assume that the simulated issuer asset returns are correlated properly.
The next step is to define the rebalancing structure in the model. The basic objective in the multi-period
setting is to simulate the end-of-period credit ratings for each period ( CRtk ,i for k 3,6,9,12 ), while only the
initial credit rating ( CRt ,i ) is known. Obviously, this simulation is performed for each position i in the
portfolio (for i 1,..., n ). As mentioned, the credit rating on which the end-of-period rating is based, is either
the end-of-period credit rating of the previous period ( CRt k 3,i ) if no rebalancing has occurred, or the initial
credit rating of the original issuer underlying the position ( CRt ,i ) if the position is rebalanced to the initial risk
level at the end of the previous period. To devise a mathematical expression that displays these conditions, the
credit rating on which the simulated end-of-period rating is based is defined as the input credit rating: ICRt k ,i .
The credit rating simulation specification is as follows: CRt3,i is dependent on ICRt 3,i , CRt6,i depends on
ICRt 6,i , CRt 9,i on ICRt 9,i and CRt 12,i on ICRt 12,i . One can interpret ICRt k ,i as the credit rating underlying
position i at the start of the period that ends at time t k .
Subsequently, an expression must be derived concerning the value (the credit rating) that variable ICRt k ,i must
hold in each single-period for each specific position i . Basically, if rebalancing has occurred at the end of the
previous period then ICRtk ,i CRt ,i and if no rebalancing has occurred then ICRtk ,i CRtk 3,i . Rebalancing
should occur when one of two conditions is met:
(1) either the end of the liquidity horizon has arisen, or
(2) the issuer underlying the position has defaulted.
To derive these conditions in mathematical terms, the length of the liquidity horizon of a position is defined
as qi and the numerical value of each single-period as h , which is simply equivalent to k / 3 when the length
of a single period is three months ( h k / 3 ). Consequently, each single-period input credit rating ICRt k ,i
underlying each position i can be expressed as:
ICRt k ,i
CRt k 3,i
CRt ,i
CR
t ,i
if CRt k 3,i D and k 3 qi h

if CRt k 3,i D
(1.9)
if k 3 qi h for h 1,2,3,4
for k 3,6,9,12 and i 1,..., n .

The equations that employ the first condition, CRtk 3,i D and CRtk 3,i D , are easily understood, since
they entail nothing more than the identification of either a simulated default of position i in the previous
single-period ( CRtk 3,i D ) or a non-default in the previous single-period ( CRtk 3,i D ).
The expression of the second condition, k 3 qi h , must be clarified in more detail. Essentially, the equation
states that rebalancing has occurred at the end of the previous period, when the end of previous period ( k 3 )
is equal to one or multiple times the length of the liquidity horizon ( qi h ). Hence, when this condition is
satisfied the input credit rating ( ICRt k ,i ) must be equal to the initial risks credit rating ( CRt ,i ).
23
The last step in the construction of the credit rating simulation model is to combine all the variables that are
defined above into a single multi-period credit rating simulation expression:
CRt k ,i
D
CCC / C
BB
BBB
A
AA
AAA
if xt k ,i Z ICR
t k ,i D
if Z ICR
t k ,i D
xt k ,i Z ICR
t k ,i CCC
if Z ICR
if Z ICR
if Z ICR
xt k ,i Z ICR B
B xt k ,i Z ICR
BB
,
Z
BB
t k ,i
ICR
BBB
if Z ICR
if Z ICR
if Z ICR
xt k ,i Z ICR A
A xt k ,i Z ICR
AA
x
AA
t k ,i
t k ,i CCC
t k ,i
t k ,i
t k ,i
t k ,i
t k ,i BBB
t k ,i
t k ,i
(1.10)
t k ,i
t k ,i
t k ,i
for k 3,6,9,12 and i 1,..., n ,

where ICRt k ,i
CRt k 3,i
CRt ,i
CR
t ,i
if CRt k 3,i D and k 3 qi h

if CRt k 3,i D
if k 3 qi h for h 1,2,3,4
The end-of-period credit rating ( CRtk ,i ) for each position i for each period is computed by applying the asset
returns thresholds (Z-values) in exactly the same way as in the CreditMetrics model. The only differences with
the CreditMetrics model are that four credit rating are simulated (one for the end of each period) instead of
only one and that the formulation of the input credit ratings is more difficult due to rebalancing requirements.
The application of the above expression ensures that for each position i in the portfolio the input credit
rating for each single-period can be determined ( ICRt k ,i for k 3,6,9,12 and i 1,..., n ) and that subsequently
the simulated end-of-period credit rating can be computed ( CRtk ,i for k 3,6,9,12 and i 1,..., n ). Herein,
the input credit rating of each position in each single-period is used to calibrate the asset return thresholds in
the simulation of end-of-period credit rating for each single-period. Obviously, the initial credit rating is
already known. This initial rating is equal to the credit rating at the start of the first period ( CRt ,i ICRt 3,i ).
1.3.2 Valuation
The next topic in the multi-period simulation model is the valuation of each position at the end of the capital
horizon. The information that is required in this valuation process is the output of the credit rating simulation
( CRtk ,i and ICRt k ,i for k 3,6,9,12 and i 1,..., n ). Moreover, the value of each position at the end of every
single-period for each possible credit rating has to be computed as well.
In this study, only corporate bond portfolios will be assessed in the model estimations, since this simplifies the
exercise considerably. In addition, only the US corporate bond market is considered.14 To obtain the values of
the bonds at the end of each single-period in the model for each possible credit rating (except default),
forward bond (re)valuation is applied. In other words, the remaining cash flows of each position i are
discounted at the forward zero credit curve of the relevant credit rating:
Mi
Vt CRk ,tik ,i
m k
CFm,i
(1 f[ kCRtmk],,it )( k 12)/12
(1.11)
for k 3,6,9,12 and i 1,..., n , where CRt k ,i D .

In this equation, CFm,i is a cash flow (coupon payment or notional payment) at time m , M i is the maturity of
the bond in months ( m is in months as well), CRtk ,i is the simulated credit rating at time t k (the end of
each single-period in the model) and f[ kCRm],t is the forward zero credit yield of rating CRtk ,i , observed at time
t k ,i
14
Under the assumption that the holder of the portfolio is located in the US, currencies are not an issue.
24
t , referring to the period between k months (the point for which the value of the position is calculated) and
m months from now (the time at which the cash flow occurs).
Obviously, the value of a position that is subject to default cannot be estimated with credit curves. Therefore,
the above expression only applies when the simulated credit rating at time t k is not equal to D (default).
The value of a defaulted position ( VtDk ,i ) is approached as follows:
Vt Dk ,i rr EADi ,
(1.12)
where rr is the (discounted) recovery rate and EADi is the exposure at default.
In this expression, the (discounted) recovery rate is assumed to be stochastic, as it is highly uncertain (volatile)
in reality. The exact details of the value of a position at default will be discussed in the next section.
The above equations ensure that all corporate bonds can be valued at the end of each single-period and for
every credit rating, including default. Applying this information, the value of each position i in the portfolio
at the end of the capital horizon ( Vt 12,i ) can be calculated. Note that the value of a position at the end of the
capital horizon ( t 12 ) is not simply equal to the value of the position at the end of the last period (also
t 12 ) given its simulated credit rating at that particular moment ( CRt 12,i ), as losses and gains resulting from
rebalancing are ignored in this value. To account for possible rebalancing results at the end of each singleperiod in the valuation of position i at the end of the capital horizon, the following valuation expression must
be applied:
3/4
1/2
1/4
,i
,i
,i
Vt 12,i Vt CR12,t i12,i (1 f[3CRt12],
Rt 3,i (1 f[6CRt12],
Rt 6,i (1 f[9CRt12],
Rt 9,i ,
t)
t)
t)
for i 1,..., n , where Rt k ,i Vt CRk ,i Vt ICR

k ,i
t k ,i
t k 3,i
(1.13)
for k 3,6,9 .
The expression implies that the value of position i at the end of the capital horizon is equal to value of the
position at the end of the last period ( t 12 ), given its simulated credit rating at that moment ( CRt 12,i ), plus
the rebalancing results of the previous single-periods ( Rt k ,i for k 3,6,9 ), which are carried to the end of the
capital horizon at a forward zero credit yield. The rebalancing results are defined as the difference between the
value of the position at the end of each single-period ( VtCRk ,i ) given the simulated credit rating at that moment
( CRtk ,i ), and the value of the position at the same point in time ( Vt ICR
) given the credit rating at the start of
k ,i
the next period ( ICRt k 3,i ).
The expression simply states that the position is sold at the end of each period and that the same position with
the input credit rating of the next period is bought again. The values of both these positions are equal when
no rebalancing occurs and therefore yield no result at such moments. When rebalancing does occur, the
difference between both values displays exactly what the losses or gains of rebalancing are at that moment.
These gains or losses do not occur at the end of the capital horizon and therefore they are pushed into the
future, applying the relevant forward zero credit yield (or more specifically, the relevant forward accrual rate).
t k ,i
t k 3,i
Obviously, the following question arises: Which forward zero credit yield curve should be used? Naturally, the
forward credit curve of the initial credit rating ( f[ kCR12],t ) is an appealing accrual rate in this setting, as it is
consistent with the formulation in the simulation model and the constant or initial risk assumption. Moreover,
applying the forward zero credit yield corresponding to the credit rating of the position that is sold at the
rebalancing moment is not always possible. This position could be in default, yet there is no available credit
yield curve for the default rating.
Nonetheless, from a portfolio point of view the forward credit yield of initial credit rating is less appealing,
since rebalancing profits on a AAA-position would be pushed forward in time with a different yield than
losses on a B-position that occur at the same point in time. In such a setting, when the rebalancing of one
position results in a profit while the other position results in a loss, these profits and losses would naturally
cover each other in a portfolio, which implies that the same accrual rate should be applied. The resulting
alternative is the construction of a value-weighted credit curve based on the credit ratings of the positions in
t ,i
25
the portfolio and the relative exposure in the portfolio to each credit rating. Nevertheless, this curve would
have some theoretical and practical issues. For example, most rebalancing results can be expected to be
generated on the lower rated positions. Consequently, the value-weighted yield curve may not be conservative
enough, since it is applied more often to the lower rated positions than implied by the value-weighted share of
these positions in the yield curve.
Hence, carrying the rebalancing results forward at the forward zero credit yield with respect to the initial credit
rating seems like the most viable option that takes into account a reasonable level of (opportunity) costs of
capital.15 Therefore, in the model estimations in Part III, this methodology will be applied for the valuation of
the positions. (The forward accrual rate issue will be discussed more thoroughly in Part III section 3.2.6.)
The valuation model above applies to corporate bonds only. However, it is important to be aware of the fact
that any type of credit product can be inserted in the proposed model, as long as the change in value as a
result of migration or default can be clearly assessed. The value and revaluation of the respective credit
product as a result of upgrading, downgrading, default or retaining of the initial credit rating are the only types
of specific information that are required in model of the type constructed here. Hence, the model can easily be
extended to cover a multitude of different credit products.
To complete the valuation component of the simulation model, the value of the complete portfolio in a
simulation scenario must be obtained. Obviously, this value is the sum of all individual position valuations in a
single simulation scenario. The valuation of the portfolio in any given simulation scenario ensures that by
generating a large number of simulation scenarios a portfolio value distribution at the end of the capital
horizon can be produced. How this distribution is assessed to obtain the relevant risk measure is addressed in
section 1.3.4. First, the default value is discussed in more detail.
1.3.3 Default Value
The default value or recovery value ( VtDk ,i ) was addressed only briefly in the previous section. In this section,
first, the standard modelling practices of the default value in this particular model setting are addressed.
Subsequently, a modification to this standard default value model is introduced. The modification is proposed
to be able to deal with some critical issues that will emerge when the standard default value model is applied in
the model estimations in Part III.
In a standard default value model, the expression of the result at the end of a period ( t k for k 3,6,9,12 )
when a default occurs is as follows (this expression was also presented in the valuation section):
t k 3,i
,
Rt k ,i Vt Dk ,i Vt ICR
k ,i
(1.14)
where VtDk ,i rr EADi , rr is the recovery rate and EADi is the exposure at default.
A position is always rebalanced right after a default occurs and as a consequence the value of the new position
after rebalancing will always refer to the initial credit rating ( Vt ICR
Vt CRk ,i ). This value can easily be computed
k ,i
with the use the forward bond valuation procedure that was assessed in the previous section. Hence, the
calculation of VtDk ,i is the point of interest. Herein, the primary driver of the default value is the recovery rate
or discounted recovery rate.
t k 3,i
15
t ,i
A third alternative forward accrual rate is the risk free forward rate. The application of this forward rate would be consistent with
the going concern principle, as losses are refunded from the regulatory capital buffer. In this setting, however, gains would be used
to increase capital or would be invested in the risk free rate, which is quite unrealistic. Moreover, the use of the risk free forward
rate is the least conservative option, since the simulated losses on the individual positions accrue at the lowest rate possible. The
decision to use the forward yield of the initial credit rating is therefore motivated by conservatism as well. Nevertheless, one must
recognize that the use of the risk free rate in this context is an option that may be applied in practice. It is, however, highly unlikely
that the interpretations and conclusions regarding the model estimations, presented in Part III, will change when the risk free rate is
used, as the VaR-estimates will be lower, but are highly likely to display very similar pattern relative to each other. The results in Part
III can thus be seen as the upper limits (the most conservative) of the VaR-estimates regarding the forward accrual rate assumption.
26
The (discounted) recovery rate commonly expressed as:

T
PV(CF )
t
rr
t 1
EAD
(1.15)
where CFt are the cash flows occurring after the default event occurs in time range [1,T ] , which may
also be the new value of the credit product after reorganization at the issuer.
In this expression, the sum of present values of the cash flows occurring after default ( CFt ) represent the
default value: VtDk ,i . Moreover, the exposure at default ( EADi ) refers in general to the face value or notional of
the respective position: FVi . Substituting both definitions in the equation 1.15 yields:
rr
Vt Dk ,i
.
FVi
(1.16)
In a standard default value model, the variable that is required in the valuation of the position in case of a
default ( VtDk ,i ) is therefore simply calculated as:
Vt Dk ,i rr FVi .
(1.17)
In other words, the only additional requirement in the standard valuation procedure is an estimate of the
recovery value. The main problem here is that the recovery rate is highly uncertain or volatile in practice. For
that matter, it would be prudent to account for this uncertainty as well. This is achieved by utilizing a
distribution instead of a constant for the recovery rate in the simulation model. In such a setting, for each
default scenario for each position a different recovery rate is simulated, effectively generating a stochastic
recovery rate.
To implement such a stochastic recovery rate, first, estimates of the recovery rate and its standard deviation
must be obtained.16 For the standard default value model, one may consider the empirical recovery rate
distribution estimates as presented in Standard & Poors Default, Transition, and Recovery: 2007 Annual Global
Corporate Default Study and Rating Transitions (Premium).17 The properties of the recovery rate distribution for
senior unsecured bonds that are presented in this publication are as follows:
Mean
= 43.7%,
Standard deviation
= 33.0%.
Vazza et al. (2008) base these estimates on S&P recovery data from the 1987-2007 period.
Gupton et al. (1997) propose a beta-distribution to describe the recovery rate distribution, as its range can be
set to [0,1] and it is easily shaped to mimic a simple empirical distribution. Moreover, the beta-distribution has
been shown to provide a good fit to empirical loss rate data (Hansen et al., 2008). Following this proposal, the
and of the beta-distribution are calibrated such that mean and standard deviation are reflected and in a
way that the shape of the distribution resembles the one presented in Vazza et al. (2008). The mean ( ) and
variance ( 2 ) of the beta-distribution can be expressed in terms of and :
16
17
Mean:
/ ( ) ,
Variance:
.
( ) ( 1)
2
(1.18)
(1.19)
Multiple approaches in the estimation of the recovery rate exist. An excellent example is the MKMV LossCalc V2 model (Gupton
& Stein, 2005). Nonetheless, to retain a certain degree of simplicity, the recovery rate is not estimated in this study, but obtained
from an S&P publication.
This publication, Vazza et al. (2008), is the last of S&Ps Default, Recovery, and Transitions-series that contains recovery rate
estimates. Moreover, S&P estimates should be employed to maintain a consistency in data sources, as the credit migration matrices
that are estimated in Part II section 2.1 are based on an S&P dataset as well.
27
The and are set to the value of 0.550

FIGURE III - Recovery Rate Distribution
and 0.709, respectively, as such a distribution
mimics the distribution in Vazza et al. (2008)
and its first and second moment statistical
properties ( and ). Figure III displays
the resulting recovery rate distribution.
Similar to the distribution presented by
Vazza et al. (2008), the probabilities for
extremely low recovery (close to the value of
zero) as well as nearly full recovery (close to
unity) are the largest. This recovery rate
The recovery rate distribution is a beta-distribution with equal to the value of
distribution with the proposed and
0.550 and equal to the value of 0.709 and range [0,1]. The mean of the
distribution () is equal to 0.437 and the standard deviation () is equal to 0.330.
values, in combination with equation 1.17,
represent the standard default value model.
In practical terms, the default value is computed quite easily with the use of this model. If a simulation results
in a default in any of the single-periods in the model, a random drawing from the (0.550,0.709) -distribution
with a range of [0,1] is obtained to simulate the recovery rate. Using this rate, the default value can be
calculated:
Vt Dk ,i rr FVi ,
(1.20)
where rr ~ (0.550,0.709) with range [0,1] .

Nonetheless, this standard method to obtain the default value in the model estimation in Part III has two
serious issues. First of all, the recovery rate of 43.7% is definitely much too high for the market circumstances
at the estimation date of the model (01/05/2009), as the estimate is based on the 1987-2007 period. For
example, Emery et al. (2009), in a Moodys publication, present a recovery rate as low as 33.8% for senior
unsecured bonds for the year 2008, and expect it to decline even further during 2009. Moodys recovery rate
of 33.8% cannot be employed as no standard deviation is presented in the publication and more importantly,
this recovery is likely to be too high as well.18
The too high mean recovery rate of 43.7% in the recovery rate distribution in the standard default value model
generates another much more direct problem in the model estimations. Basically, the corporate bond
portfolios that will be used in the model estimation contain a high number of bonds that are valued below par,
which in its turn implies an even higher effective recovery rate relative to the market value of these positions.19
In some cases, this may even ensure that a simulated default for a position is expected to generate a profit
instead of a loss in the period it defaults.
This issue can be illustrated with an example.20 Consider a $200,000 position in the A-rated Cintas Corp bond,
with a face value of $221,925. When the credit rating simulation implies that this bond is downgraded to the
/C
CCC/C category in the first period of the model, its value at the end of the first period ( Vt CCC
) drops to
3,i
$89,352.45. If this bond subsequently defaults in the second period, its expected value at the end of the
second period is $96,981.14 ( E (Vt D6,i ) E (rr ) FVi ). Hence, a default event in this scenario will on average
generate a profit of 8.5% in the period in which the default occurs (period two). Although in practice defaults
18
19
20
Moodys expectation is based on the empirically observed inverse relation between the average probability of default and recovery
rates (this subject is discussed in Part III section 3.2.3). Since large numbers of defaults are expected in 2009, it is also expected that
recovery rates decline even further during 2009.
The construction of the corporate bond portfolios is addressed in Part II section 2.3 and the individual bonds (names) that they
comprise are presented in appendix A.3.
The values presented in this example are computed with (forward) bond valuation equation (equation 1.11) and the credit yield
curves observed at the estimation date of the model (01/05/2009). These credit yield curves are employed in the model estimations
in Part III as well and appendix A.4 provides information with respect to these credit yield curves.
28
may occasionally generate profits, an expected profit signals a significant mispricing of the particular bond,
which is highly unrealistic. Apart from the Cintas Corp bond example, there are numerous other bonds in the
assessed portfolios and numerous other scenarios for which similar unrealistic effects will emerge.
Both abovementioned issues are likely to distort the model output and its resulting risk measures. And since
no reliable recovery rate (and standard deviation) estimates can be obtained, a modification will be introduced
to default value model. Both problems are effectively cured when the default value is computed as follows:
Vt Dk ,i rr Vt CRk ,tik 3 ,
(1.21)
where rr ~ (0.550,0.709) with range [0,1] .

In this expression, the S&P recovery rate estimates are still applied, yet the default value is computed as a
percentage of the last observed market value of the bond. The modified specification ensures that each default
will generate a loss on the position. Moreover, the effective recovery rate in the model estimations, as a
percentage of the face value of the position, will be much lower than in the standard model (approximately
twice as low). The modified specification is therefore much more realistic given current market conditions and
is much more in line with expectations as well. Hence, this modified specification will be employed in the
model estimations in Part III. Do note, however, that when reliable recovery rate (distribution) estimates are
available, the standard default value model should definitely be preferred, since it is theoretically more sound
and it is consistent with the way recovery rates are commonly measured. The modification imposed in this
study is only introduced to cure the problems that the (unreliable) too high historical recovery rate estimate
will produce in the model estimations. It ensures that no arbitrary recovery rate has to be picked as well.
The stochastic default value is the last component that is required in the valuation of each position in the
model. Hence, the valuation model of the total portfolio is complete.
1.3.4 Model Output
As mentioned, the value of the complete portfolio in a simulation scenario is simply equal to the sum of all
individual position valuations in that simulation scenario. The distribution of the portfolio value at the end of
the year (capital horizon) is constructed by generating a large number of simulation scenarios, which result in a
large number of possible total portfolio values at the end of the capital horizon. From here, the 99.9%
confidence interval is obtained by taking the K /1000 worst result from the distribution, where K is the
number of simulations. Intuitively, one could argue that of every thousand simulations only one scenario has a
material impact on the 99.9% percentile. For this particular reason, a rather high number of simulations have
to be generated.
Given the number of simulations ( K ), the confidence intervals around the 99.9% interval estimate can be
computed as well, following the method assessed by Gupton et al. (1997). The estimation of these confidence
bands provides information about the certainty and precision of the 99.9% worst result. As a consequence, it
presents the opportunity for statistical inference as well. In general, when the p th percentile ( p 0.001 for the
99.9% confidence interval) is estimated with K scenarios, the confidence bands at a particular -level
( 1.960 for 95% two-tailed confidence bands) are calculated with the following formulas:
Mean ( m ):
m K p,
(1.22)
Standard deviation ( s ):
s K p (1 p ) ,
(1.23)
Lower bound ( l ):
l K p K p (1 p ) m s ,
(1.24)
Upper bound ( u ):
u K p K p (1 p) m s .
(1.25)
These expressions are the result of the assumption that the number of scenarios that fall below the true
portfolio value at the p th percentile (i.e. the true mean m ) follow a binominal distribution.
29
Eventually, following the Basel Committees requirement in determining the Incremental Risk Capital Charge,
the 99.9% value-at-risk estimate is required. This value-at-risk measure is simply computed by subtracting the
99.9% percentile estimate (the mean in the formulas above) from the initial portfolio value, which is obviously
known at the moment of the model estimation. This value, in value-at-risk terminology, is interpreted as the
dollar amount that we do not expected to lose on the portfolio in 99.9% of the cases over the period of one
year (under the assumption that the bank behaves according to the constant level of risk assumption).
The technical details in the generation of the model output obviously complete the construction of the multiperiod simulation model. The only component of the model that has not been addressed yet is the correlation
structure. Hence, the derivation of this correlation structure is addressed in the next section.
1.4
THE CORRELATION STRUCTURE

The correlation structure within the model is the system of correlations between all simulated issuer asset
returns. Needless to state in a simulation model, the correlation structure must display a close resemblance
with what is observed in the relevant financial markets. In essence, the correlation structure handles the
interactions between the credit risk of the different positions and between the different periods in the model.
Since the issuer asset returns are simply random variables from a pre-specified distribution, the construction
of the correlation structure primarily revolves around the generation of correlated random variables.
Before advancing to the technical details, first, the objectives that must realized within the multi-period
correlation structure of the proposed incremental risk model must be addressed. Moreover, the definitions
that are required to achieve this correlation structure must be specified.
1.4.1 Objectives and Definitions in the Correlation Structure

Essentially, there are three objectives that need to be achieved within the correlations structure of the
incremental risk model, such that it contains the required descriptive qualities. Similar to Gupton et al. (1997),
it is assumed that asset values (or returns) are the key drivers in the credit quality of issuers. Consequently,
asset correlations, between issuers or between periods, should capture the relations in changes in issuer credit
quality between issuers or through time. In this, it is of vital importance that credit quality correlations are
properly captured in a credit risk model that assesses complete portfolio. Correlations can generate an
enormous amount of additional risk in the portfolio context, when the credit quality of its underlying issuers
strongly moves together. Therefore, the first objective is, as in the CreditMetrics model, to describe the
correlations between the issuers underlying the credit products in the portfolio. When the proper issuer
correlations are incorporated into the correlation structure of the proposed incremental risk model, then the
interactions are accurately captured between the default and migration risks underlying all single positions in a
cross-sectional dimension.
The second objective is brought into existence by the multi-period setting of the model. Since a multi-period
model also has a time-series dimension, it would make sense to not only incorporate issuer correlations but
also incorporate issuer asset autocorrelations. In fact, to construct a realistic simulation of reality, issuer
returns should be auto-correlated, as autocorrelation and momentum are among the most commonly
observed features of financial return data. In efficient markets, it is typically assumed that market moves in
one period are uncorrelated to the next. However, with ratings and defaults, it is difficult to argue for market
efficiency, as effects like rating drift are well documented in the literature (Altman & Kao, 1992a, 1992b).21 An
underlying autocorrelation structure in the period-to-period migration risk specification effectively ensures
that rating drift is introduced in the simulation system. In the relevant literature, discussed in Part II section
2.1.6, it is demonstrated that rating drift is an exceedingly important factor to take into account in describing
21
Rating drift or rating momentum is the empirically observed phenomenon that downgraded issuers experience a higher probability
to be downgraded again than the other issuers in the rating class they were downgraded to.
30
the dynamics of credit migrations. In summary, issuer asset autocorrelations account for another source of
risk within the incremental risk model. Hence, it is no more than prudent to incorporate it in the correlation
structure of the model.
The last objective is to allow for a realistic nature of asset correlations in the correlation structure. The
CreditMetrics model assumes the relation between issuer to be linear, as common linear correlations are used
to statistically describe the relations. Moreover, it is assumed that the correlations are of Gaussian nature,
while there are better specifications of the behaviour of asset correlations available. The linearity assumption is
left untouched, yet besides the Gaussian assumption made by Gupton et al. (1997), the opportunity is created
for a much more realistic t-Student specification in the correlation structure. More details on the theoretical
backgrounds of this specification are provided in section 1.4.2 below.
Another important aspect in the creation of the correlation structure obviously is the guidelines and
requirements as set forth by the Basel Committee. The incremental risk model guidelines state that correlation
assumptions must be supported by analysis of objective data.22 The validation requirements state that the
implied issuer correlations (the result of the correlation structure) should be reasonably in line with observed
annual correlations. These statements are incorporated by estimating issuer correlations with the use of
observed financial data. The applied methodologies are described in Part II section 2.2. Basically, these
estimated or observed issuer correlations provide the input correlations to which the correlation structure is
calibrated, effectively complying with the Basel Committees validation requirements. Note that the Basel
Committee states nothing about the subject of autocorrelation. Nevertheless, it is incorporated in the
correlation structure as it should enhance the accuracy of the proposed incremental risk model.
In the creation of the proper correlation structure, first the term implied correlation has to be defined in its
context. To accomplish this, the very nature of the simulated issuer asset returns must be described. Each
(three-month) single-period simulated issuer asset return ( Rt3,im ) underlying each credit product i at time t (in
months) is defined as a normally distributed log return:
P
Rt3,im ln t ,i ~ N(0,1) ,
Pt 3,i
(1.26)
where Pt ,i is the value of the issuers assets at time t .

This single-period return is a standard normally distributed random variable that is used as a simulated issuer
asset return and will be referred to as single-period issuer asset return in the remainder of the study. Notice that the
simulated issuer asset return inputs in the simulation model ( xt ,i ) are in fact the same variable ( xt ,i Rt3,im ), since
the correlation structure is used to create these inputs.
As a result of the logarithmic specification, the simulated annual issuer return ( Rt1212,m i ) underlying each credit
product i is easily computed by summing the single-period issuer returns:23
Rt1212,m i Rt3m3,i Rt3m6,i Rt3m9,i Rt3m12,i xt 3,i xt 6,i xt 9,i xt 12,i .
(1.27)
The simulated annual issuer asset returns underlying each position are the issuer asset returns from which the
implied issuer correlations will be calculated.24 In the remainder of this study, the simulated annual issuer asset
returns underlying a single position will be referred to as the annual issuer asset return (of a position) or (an issuers)
22
23
24
The Basel Committee also states that market and issuer concentrations must be captured. In this study, it is assumed that
concentrations of this kind are reflected in the observed or estimated correlations, resulting in the incorporation of their effects into
the simulation model.
The annual asset return is defined as: Rt1y12,i ln(Pt12,i / Pt ,i ) . The sum (or convolution) of the three-month asset returns can written as:
Rt3m3,i Rt3m6,i Rt3m9,i Rt3m12,i ln(Pt 3,i / Pt ,i ) ln(Pt 6,i / Pt 3,i ) ln(Pt 9,i / Pt 6,i ) ln(Pt 12,i / Pt 9,i ) ln(Pt 12,i / Pt ,i ) , which is equal to the annual asset
return. Hence, annual return Rt1y12,i is a convolution of its four underlying three-month asset returns: Rt3m3,i , Rt3m6,i , Rt3m9,i and Rt3m12,i .
Note that it makes no difference whether the average or annual issuer return is taken to compute the model implied correlations.
The average issuer asset return is merely the annual issuer return divided by four. Then when the annual issuer asset return
underlying each position is divided by four, the correlations between these returns remain unchanged, since dividing correlated
variables by the same constant does not change their correlation properties.
31
annual asset return. Both definitions refer to exactly the same variable. These definitions ignore the fact that the
single-period returns on which the annual issuer asset return is built may refer to different issuers as a result of
rebalancing possibilities. Even so, the abovementioned definitions are applied, since it is rather inconvenient
to constantly refer to the particular variable as the annual issuer asset return underlying the position.
Using the annual issuer asset returns, the implied issuer correlations between positions i and j are defined as:
corr( Rt1212,m i , Rt1212,m j ) or corr( xt 3,i xt 6,i xt 9,i xt 12,i , xt 3, j xt 6, j xt 9, j xt 12, j )
for i 1,2,..., n and j 1, 2,..., n ,

where n is the number of credit products in the portfolio.
As mentioned, both definitions are equivalent and refer to the same variables. The objective is then to
calibrate the single-period issuer asset returns in a way such that the implied issuer correlations are in line with
estimated or observed issuer correlations.
Even though it is technically possible to create such a correlation structure in a multi-period simulation model,
it has a theoretical downside. The constant level of risk assumption implies that a position is rebalanced to its
initial risk level when the liquidity horizon has ended. Rebalancing to the initial risk level indicates, in essence,
that the original credit product is sold and a new similar hypothetical product with similar risk characteristics is
bought. This may happen multiple times before the end of the capital horizon, implying that the single-period
issuer asset returns underlying a single position may refer to multiple issuers. Nevertheless, the evaluation of
the issuer correlations is based on the entire capital horizon, using the single-period asset returns of different
issuers to compute the annual issuer asset return of a position. The fact that multiple underlying issuers can
generate a single annual or average issuer asset return for a single position does not make much sense
theoretically.25 Even so, complications of this kind may be inherent to any application of different liquidity
horizons for different positions within one capital horizon that is equal for all positions.
1.4.2 Copulas
Given the abovementioned objectives and definitions, the required correlation structure can be derived. As
mentioned, the creation of the correlation structure revolves around the generation of correlated random
variables. To understand the basics behind the generation of correlated random variables, or correlated
simulation issuer asset returns in the context of this study, first the method in which correlated issuer asset
returns are generated in the CreditMetrics model must be assessed. Although not explicitly stated in the
document, the CreditMetrics model utilizes the Gaussian copula in order to achieve its single-period
correlation structure. The basic setting is that a large number of simulation scenarios are generated with the
use a pre-specified asset return distribution assumption. Gupton et al. (1997) apply the standard normal or
Gaussian distribution to generate simulated asset returns for each underlying issuer in the assessed portfolio.
In order to correlate these simulated asset returns, the Gaussian copula is required.
Copulas in general provide a mathematical approach to specify the relations between distributions.26 Hence,
they are a great tool in the modelling of such relations. The most important work with respect to copula
function can be traced back to Sklar (1959), who demonstrates the importance of copulas as a universal tool
for studying multivariate distributions.27 The most commonly applied copula function is the Gaussian copula,
which assumes normally distributed issuer asset returns and linear correlations in this migration risk context of
25
26
27
Similar complications resulting from the constant risk assumption in the incremental risk model are addressed by Finger (2009).
Numerous other theoretical problems of the constant level of assumption are discussed in detail in Part III section 3.2.5.
The mathematical descriptions of the Gaussian copula as well as the t-Student copula in this section are largely based on Abid &
Naifar (2007).
The original definition of the copula is provided by Sklar (1959). Sklars theorem, which is presented in that same publication, is
considered the most important theorem in the area of copula functions.
32
this study. The frequent use of this copula can be attributed by the fact that the multivariate normal
distribution has two appealing characteristics: (1) their marginal distributions are normal and (2) it can be fully
described by their marginal distributions and a covariance-matrix.
For univariate margins F1 ,..., Fn which are Gaussians, the dependence structure among the margins is
described by a unique normal copula function. Let x1 ,..., xn be random variables which are standard normal
distributed with means 1 ,..., n , standard deviations 1 ,..., n and correlation matrix C . Then, the
distribution function CCGa (u1 ,..., un ) of the random variables ui [( xi i ) / i ] with i {1,..., n} is a Gaussian
copula with correlation matrix C . The cumulative univariate standard normal distribution function is denoted
by (.) . The Gaussian copula is written as:
CCGa (u1 ,..., un ) C [ 1 (u1 ),..., 1 (un )] ,
(1.28)
where C (.) is the standard multivariate normal distribution function with linear correlation matrix C
and 1 (.) is the inverse of the standard univariate normal distribution function.
The corresponding density function is given by:
1
CCGa (u1 ,..., un ) | C |1/2 exp [ 1 (u)]'[C1 I n ] 1 (u) ,

2
(1.29)
where | C | is the determinant of correlation or covariance matrix C , 1 (u) [1 (u1 ),..., 1 (un )]' and
In is the n -dimensional identity matrix.
In the bivariate case, where n 2 , the correlation coefficient 12 in correlation matrix C is the only Gaussian
parameter.
In the CreditMetrics model, standard normally distributed random variables are utilized, which are correlated
through the application of the Gaussian copula. Here, the problem is to generate x ( x1 ,..., xn ) ' where
x ~ MN( C) and C is the correlation matrix regarding all issuers in the portfolio.
The followings steps are taken to solve this problem:28
- Calculate the Cholesky decomposition ( L ) of correlation matrix C , such that C L ' L .
- Simulate n independent standard normal random variables z ( z1 ,..., zn )' ~ MN(0,1) .
- Compute L ' z x , then x is an n -dimensional vector x ( x1 ,..., xn ) ' of standard normally distributed
variables from the n -dimensional Gaussian copula CCGa . Thus, x ~ MN( C) .
Vector x contains the correlated simulated asset returns of one scenario in the CreditMetrics model.29
The intuition behind the Gaussian copula is quite simple. Consider two independent random drawings from
the standard normal distribution. In an issuer asset return simulation, this would translate into two simulated
asset returns for two different issuers. The two issuer asset returns are independent and therefore have a
correlation equal to zero. When the above steps are applied to introduce a correlation between both issuer
asset returns, the asset return of the first issuer is left unchanged, whereas the one of the second issuer is
modified by combining it with the one of the first issuer. A new asset return for the second issuer is created
that is normally distributed and correlated to the return of the first issuer. The result is that when the first
issuer has a low simulated asset return (below zero), then if the introduced correlation is positive, the second
issuers return is more likely to be low as well (below zero). Hence, the downgrade and default probabilities
for the second issuer are larger than the credit migration matrix implies in that particular simulation scenario.
The only required assumption is that the relation between both issuer asset returns is of a Gaussian nature.
28
29
The problem is to generate x ( x1,..., xn )' where x ~ MN( C) . Suppose then that zi ~ N(0,1) and i.i.d. for i 1,..., n . Then
c1 z1 ... zncn ~ N(0, 2 ) , where 2 c12 ... cn2 , since a linear combination of random variables is again normally distributed. More
generally, if L is an n x n matrix and z ( z1 ,..., zn )' then L ' z ~ MN(0, L ' L) . The problem of generating correlated random
variables is simply solved with the equation: L ' z x . See Haugh (2004) for a more detailed explanation.
The CreditMetrics model, in its simplest form, actually proposes a bivariate Gaussian copula based on a factor model, which can
also be implemented with the multivariate Gaussian copula that is presented in this section.
33
In addition to the Gaussian assumption, there are numerous other distributional copula assumptions that can
be applied in a simulation framework such as the CreditMetrics model. For that matter, the Students t-copula
is applied as well in the correlation structure of the model that is proposed in this study. The Gaussian copula
preserves the underlying distribution of the individual random variables but the joint distribution is like a
multi-dimension Gaussian. This structure naturally assigns little weight to the tails. However, in practice,
financial market (equity or asset return) data is frequently subject to fat tails (excess kurtosis). Moreover, it is
more often than not the tails that are most interesting. Then if one desires a fat tailed distribution similar to
the Gaussian, the obvious choice is the Students t-distribution.
Blattberg & Gonedes (1974) introduced the Students t-distribution as a model of asset returns. Since then,
this model has become a benchmark for asset return models. The Students t-distribution is an attractive
model since it is able to capture the excess kurtosis observed in financial time-series. Furthermore, its
mathematical properties are well known. The Students t-distribution is mainly a descriptive model that seems
to fit financial data well and for this reason it has been applied very frequently in finance. Tyli (2002) for
example, assesses a large number of asset return models and finds that the Students t-distribution generally is
the best fitting model for financial asset return data.30 In addition, LeBaron (2009) shows that the Students tdistribution provides a fairly good approximation of tails distributions of stock return data.31 These descriptive
qualities of this distribution is exactly what is required in the correlation structure of the incremental risk
model, as the accuracy of a simulation model generally dependents on such qualities.
The Students t-copula is the Students t-distributions variant in the assessment of linear correlation between
variables. Obviously, the t-Student copula provides a different specification of the link between multiple
distributions than the Gaussian one. It incorporates the appealing tail dependence that can be found in a
univariate t-distribution into the linear dependence in the multivariate context. The t-Student copula is
obtained in a similar way as the Gaussian copula. Instead of the Gaussian distribution the t-distribution is
used:
( n )/2
Ct ,C (u1 ,..., un ) | C |1/2
T1 (u) ' C1T1 (u)

1
n 1
[( n) / 2] ( / 2)
1)/2
d
n [( 1) / 2]
[T1 (u)]2
i 1
, i {1,..., n} ,
(1.30)
where C is again the correlation matrix, T1 (u) [T1 (u1 ),..., T1 (un )]' , T1 (.) is the inverse of the
univariate t-Student cumulative distribution function, is the degree of freedom and (.) is the
gamma function.
In the bivariate case, the copula has two parameters: the degrees of freedom ( ) and correlation coefficient
( 12 ) from correlation matrix C .
The followings steps have to be taken to generate t-distributed random variables, with degrees of freedom,
that are correlated through the t-Student copula x ( x1 ,..., xn ) ' ~ Mt (0, C) :
- Calculate the Cholesky decomposition ( L ) of correlation matrix C , such that C L ' L .
- Simulate n independent standard normal random variables z ( z1 ,..., zn )' ~ MN(0,1) .
- Simulate a random variable ( s ) from the 2 -distribution, independent of z .
- Compute L ' z y .
- Set x y / s , then x is an n -dimensional vector x ( x1 ,..., xn ) ' of Student t-distributed variables
from the n -dimensional t-Student copula Ct ,C . Thus, x ~ Mt ( C) .
Vector x contains the correlated simulated asset returns of one scenario under the much more realistic tStudent assumption.
30
31
Tyli (2002) utilizes more than 32 years of S&P500 data and 7 years of Helsinki Stock Exchange data.
LeBaron (2009) uses a small set of individual US stocks with a very long sample period: 1926 - 2004.
34
In the application of this copula, one alteration relative to the Gaussian CreditMetrics simulation structure is
still required. Namely, the asset return thresholds (Z-values) described in section 1.2.2, have to be computed,
using the cumulative univariate Students t-distribution function t (.) instead of the Gaussian (.) .
Notice that the creation of correlated Students t-distributed random variables follows the exact same first
steps as the creation of correlated standard normally distributed random variables. This basically implies that a
system of correlated Gaussian random variables can be easily converted into a system of Students tdistributed random variables with the exact same correlation structure. Only the last of the above steps is
required to accomplish such a distribution conversion.
1.4.3 The First Copula: Issuer Correlations
Both copulas, the Gaussian and the t-Student, would have practically completed the model in a single-period
setting such as the CreditMetrics model. In such a single-period model, the product-specific migration risk
would have been described by the credit migration matrix and issuer asset correlations would have been
handled by either the Gaussian copula or the t-Student copula. Nonetheless, the correlation structure that is
required in the proposed incremental risk model has a multiple-period nature.
Hence, a multiple period correlation structure must be constructed. In this process, only a Gaussian
correlation structure will be addressed, since this Gaussian structure can be easily converted into a Students tstructure. First, the required structure for the four-period model is derived, without the incorporation of
autocorrelations. Such a structure is relatively easy to derive, as it is nothing more than a sequence of four
independent CreditMetrics correlation structures.
Consider two positions, A and B. The input correlation or observed credit quality correlation between the two
is defined as AB (which is the only entry that is not equal to unity in the corresponding two-dimensional
correlation matrix C of position A and B). For both positions four single-period issuer returns are simulated:
x A,t 3 , x A,t 6 , x A,t 9 , xA,t 12 and xB ,t 3 , xB ,t 6 , xB ,t 9 , xB ,t 12 ,
where xi ,t ~ N(0,1) .
Furthermore, assume that the Gaussian copula, as discussed in the previous section, is applied in all four
periods, using the same correlation matrix ( C ) in all periods. In essence, the four correlated simulated returns
per position are nothing more than the elements of four x ( xA , xB ) ' vectors, resulting from the last step of
the application of the Gaussian copula. As a result of the copula application, the correlation properties of the
single-period issuer asset returns are simply described as:
corr( xA,t 3 , xB ,t 3 ) corr( xA,t 6 , xB ,t 6 ) corr( xA,t 9 , xB ,t 9 ) corr( xA,t 12 , xB ,t 12 ) AB .
(1.31)
Then if the single-period issuer asset returns are summed for both positions to form the annual issuer asset
returns ( R12A,tm12 and RB12,tm12 ), the correlation between both is equal to AB as well:
m
12 m
corr( R12
A,t 12 , RB ,t 12 ) corr( xA,t 3 xA,t 6 xA,t 9 xA,t 12 , xB ,t 3 xB ,t 6 xB ,t 9 xB ,t 12 ) AB .
(1.32)
This statement is mathematically valid, since each positions single-period issuer asset returns are independent
of each other and the correlation between the two positions single-period asset returns is equal in all periods.
Hence, the implied issuer correlation is equal to the input issuer asset correlation in correlation matrix C .
Nevertheless, this simple correlation structure does not yet contain any form of autocorrelation. To attain a
structure that also displays autocorrelation a second copula must be applied.
1.4.4 The Second Copula: Autocorrelations
As mentioned, the incorporation of autocorrelation in the correlation structure is likely to enhance the
descriptive qualities of the simulation model. To circumvent the complete specification of underlying autoregressive risk factors, which could become problematic as more assumptions would be required, one may
incorporate period-to-period correlation by using issuer-specific asset return autocorrelation. The rationale
35
behind this approach in terms of risk factors is that if all issuers are tied together with their correlations and if
all issuer returns are dependent on themselves a period ago, then the risk factors are implicitly accounted for
when the dependence of these issuer returns on each other is correctly specified. There is no real need in this
study to assume an underlying risk factor model when the result (the observed correlations) is known and can
be replicated in the correlation structure. In addition, the introduction of a general autoregressive risk factor,
with a positive AR coefficient, implies that each issuers asset returns exhibit positive autocorrelation, while
some may experience negative autocorrelation or a mean reversion effect in reality.
In order to incorporate of issuer-specific autocorrelation for position i (for i 1,2,..., n ), assume that the first
Gaussian copula has been applied in each single-period, correlating all n positions single-period issuer asset
returns in each period according to correlation matrix C in the cross-section dimension. The four singleperiod issuer asset returns for each position i are again defined as:
xi ,t 3 , xi ,t 6 , xi ,t 9 and xi ,t 12 ,
where xi ,t ~ N(0,1) .
Subsequently, issuer-specific autocorrelation is introduced: corr( xi ,tk 3 , xi ,t k ) for k 6,9,12 (the first period
obviously cannot be auto-correlated to a previous return). A correlation can be introduced between xi ,t k 3 and
xi ,tk by applying a bivariate Gaussian copula expression:32
xiAC
1 i2, AC xi ,t k ,
,t k i , AC xi ,t k 3
(1.33)
where i , AC is the issuers autocorrelation coefficient.

After this conversion, xiAC,tk is (auto)correlated to xi ,t k 3 with magnitude i , AC . The conversion of xi ,tk to xiAC,tk is
employed for the returns underlying each single position ( i 1,2,..., n ) for k 6,9,12 .
To obtain the annual issuer asset return, the period one issuer asset return and the converted single-period
AC
AC
1y
issuer asset returns of position i are summed ( xi ,t 3 xiAC
In this setting, the
,t 6 xi ,t 9 xi ,t 12 Ri ,t 12 ).
autocorrelation is equal to i , AC and may differ for each issuer. In contrast to the result of the previous
section, the terms of the summation are not independent in this case. Hence, the correlation properties of the
annual issuer asset returns may deviate from those introduced in the single-period issuer asset returns
(correlation matrix C ). In other words, the implied issuer correlations are only in reasonable accordance with
correlation matrix C , while the autocorrelation underlying each position is equal to i , AC . The deviation from
correlation matrix C will be approached in the next section. In addition, a correction is devised.
1.4.5 Effects of the Second Copula
The second dimension of correlations, the autocorrelations, in the single-period issuer asset returns affect the
issuer correlation properties of the converted variables ( xhAC,i ). This effect induces a deviation of the implied
issuer correlations from correlation matrix C . The magnitude of these deviations can be approached.
Consider two positions, A and B, in a two-period model. The period returns of these issuers are defined as:
xA,1 and xAAC,2 for position A,
and xB ,1 and xBAC,2 for position B.

The objective here is as follows: xAAC,2 should be auto-correlated to xA,1 with autocorrelation coefficient A, AC
and xBAC,2 should be auto-correlated to xB ,1 with autocorrelation coefficient B , AC . The implied issuer correlation
should be equal to AB . Hence, corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) should take on the value of AB .
32
This expression is nothing more than the matrix multiplication of both independent simulated issuer asset returns with the Cholesky
decomposition of the correlation matrix in a bivariate setting.
36
To craft this correlation structure, first the correlation ( AB ) between the single-period returns of issuers,
underlying positions A and B, is introduced in both periods with the first Gaussian copula:33
2
xB ,1 x A,1 AB 1 AB
z1
2
and xB ,2 x A,2 AB 1 AB
z2 ,
(1.34)
(1.35)
where xA,1 , xA,2 , z1 and z2 are independent standard normally distribution random variables, implying
that xB ,1 and xB ,2 are also standard normally distributed random variables that are correlated to xA,1 and
xA,2 , respectively, with magnitude AB (issuer correlation in the cross-sectional dimension).
Subsequently, autocorrelation is introduced by applying the second Gaussian copula for both positions by
forming variables xAAC,2 and xBAC,2 , utilizing xA,1 , xA,2 , xB ,1 and xB ,2 :
x AAC,2 x A,1 A, AC 1 B2 , AC xA,2
(1.36)
and xBAC,2 xB ,1 B , AC 1 B2, AC xB ,2 ,
(1.37)
where xAAC,2 and xBAC,2 are standard normally distributed and correlated to xA,1 and xB ,1 with magnitudes
A, AC and B , AC , respectively (issuer-specific autocorrelation in the time-series dimension).
As a result of the above procedure, the single-period issuer asset returns for both positions are created ( xA,1
and xAAC,2 for position A and xB ,1 and xBAC,2 for position B). The issuer correlation in period one is still equal to
AB , since xA,1 and xB ,1 have not been subject to another conversion. A difficulty arises, however, with the
issuer correlation in period two which has been affected by the autocorrelation of the second copula. The
effect can be mathematically approached (appendix A.1 describes this derivation in more detail). From
equations 1.34, 1.35, 1.36 and 1.37, it can be shown that:
x AAC,2 x A,1 A, AC x A,2 1 A2 , AC ,
(1.38)
2
2
xBAC,2 x A,1 B , AC AB x A,2 1 B2 , AC AB z1 B , AC 1 AB
z2 1 AB
1 B2 , AC .
(1.39)
In this setting, the second-period asset returns underlying both positions are rewritten in terms of independent
random variables. Here, the following statistical rule holds: when a ~ N(0,1) is correlated to b ~ N(0,1) and
b is correlated to c ~ N(0,1) , then the correlation between a and c is equal to corr(a, b) times corr(b, c) , or
in more statistical definitions: ac ab bc . Applying this rule, the correlation between xAAC,2 and xBAC,2 can be
derived:
corr( x AAC,2 , xBAC,2 ) AB ( A, AC B , AC 1 A2 , AC 1 B2 , AC ) .
(1.40)
Thus, corr( xAAC,2 , xAAC,2 ) is only equal to AB when ( A, AC B , AC 1 A2 , AC 1 B2 , AC ) 1 , which is only the case
when both autocorrelation coefficients hold equal values ( A, AC B , AC ). In practice, autocorrelation
coefficients of different issuers will not be equal and therefore: corr( xAAC,2 , xBAC,2 ) AB . In a model with more
than two periods, the deviations of the period-specific issuer correlations relative to correlation matrix C can
be derived in a more complicated but similar fashion. Moreover, the issuer correlations in the single-period
returns have to deviate from C when the total annual issuer returns (the sum of all period returns per issuer)
are correlated correctly, as the autocorrelations and therefore, the issuer correlations of each period all
influence the issuer correlation properties of the annual issuer returns of the positions. Basically, as mentioned
before, the sums of dependent standard normal random variables, the annual issuer returns, have different
correlation properties than their underlying components, the single-period issuer returns, as a result of the
dependency between these underlying components in the sums.
33
The first Gaussian copula (the copula in the cross-sectional dimension) is bivariate in the two-position example, but is multivariate
when it is applied to a portfolio with more than two positions. Do not confuse this Gaussian copula application with the more
commonly used single factor model bivariate copula with a common economic factor and an issuer-specific idiosyncratic factor.
37
In the two-period, two-position example, the implied issuer correlation between position A and position B can
be derived with the standard statistical correlation expression:
corr( xA,1 xAAC,2 , xB ,1 xBAC,2 )
cov( xA,1 xAAC,2 , xB ,1 xBAC,2 )

var( xA,1 xAAC,2 ) var( xB ,1 xBAC,2 )
(1.41)
Applying the fact that E ( xA,1 ) E ( xAAC,2 ) E ( xB ,1 ) E ( xBAC,2 ) 0 , var( xA,1 ) var( xAAC,2 ) var( xB,1 ) var( xBAC,2 ) 1 and
the definition of corr( xAAC,2 , xBAC,2 ) , as derived in equation 1.40, the implied correlation can be expressed in terms
of issuer correlation and autocorrelations:
corr( x A,1 x AAC,2 , xB ,1 xBAC,2 ) AB
1 A, AC B , AC A, AC B , AC 1 A2 , AC 1 B2 , AC
(2 2 A, AC )(2 2 B , AC )
(1.42)
The complete explanation of the derivation of this expression of the implied issuer correlation is presented in
appendix A.1. The equation implies that corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) is equal to AB only when:
(2 2 A, AC )(2 2 B , AC )
1.
(1.43)
Again, this condition only holds when both autocorrelation coefficients are equal in magnitude ( A, AC B , AC ).
If they take on different values ( A, AC B , AC ), then the fraction in equation 1.42 and 1.43 will be smaller than
the value of one, meaning that the implied issuer correlation ( corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) ) will always be lower
than the input issuer correlation value ( AB ). A larger difference between both autocorrelation coefficients
results in a larger downwards deviation from the input issuer correlation. This downwards deviation, however,
will never be unreasonably large. For example, consider the autocorrelation coefficients A, AC 0.33 and
B, AC 0.33 , which are the maximum and minimum of the issuer-specific autocorrelation coefficients that are
obtained and used in this study. In addition, assume that the observed input correlation is equal to 0.6
( AB 0.6 ). Applying these values in equation 1.42 yields corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) 0.9611 AB , which implies
that corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) 0.5767 . This rather small difference demonstrates that although the implied
correlation is always smaller than AB , the difference will not be unreasonably large. Even so, a correction is
possible by rewriting equation 1.42:
*
AB
AB /
(2 2 A, AC )(2 2 B , AC )
(1.44)
*
The input issuer correlation ( AB ) must replaced in the model by the corrected input issuer correlation ( AB
).
*
In other words, AB must be used in the application of the first copula (the cross-sectional copula) for the
single-period issuer asset returns for each period in the model. This will ensure the implied issuer correlation
in the model ( corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) ) is equal to the original input issuer correlation ( AB ). The corrected input
issuer correlation essentially identifies which issuer correlation must be inserted in the first copula to end up with the proper implied
correlation after the application of the second copula. It ensures that the autocorrelation and the correct implied
correlation can exist together in the simulated issuer returns in the model. Herein, however, a new problem
arises. Namely, the formula that yields the corrected input issuer correlation becomes increasingly complicated
when the number of periods in the model is increased. For example, in the four-period model that is proposed
in this study the correction formula is as follows:
*
AB
AB / 1 A, AC A2 , AC A3 , AC B , AC A, AC B , AC 3 1 A2 , AC 1 B2 , AC A2 , AC B, AC
2 A, AC 1 A2 , AC 1 B2 , AC A3 , AC B , AC A2 , AC 1 A2 , AC 1 B2 , AC B2 ,AC A ,AC B2 ,AC

2 B , AC 1 A2 , AC 1 B2 , AC A2 , AC B2 , AC 2 A, AC B , AC 1 A2 , AC 1 B2 , AC A3 , AC B2 , AC
A2 , AC B , AC 1 A2 , AC 1 B2 , AC B3 , AC A , AC B3 , AC B2 ,AC 1 A2 ,AC 1 B2 ,AC A2 ,AC B3 ,AC
A, AC B2, AC 1 A2, AC 1 B2, AC A3 , AC B3 ,AC A2,AC B2,AC 1 A2,AC 1 B2,AC

/ 4 2 A3 , AC 4 A2 , AC 6 A, AC 4 2 B3 , AC 4 B2, AC 6 B , AC
38
(1.45)
To derive this correction (or a correction for a model with more periods), first, issuer asset correlation
between the two positions, A and B, in the cross-sectional dimension must be introduced by applying the first
copula in each of the single-periods in the model (like equation 1.34 and 1.35 in the two-period example).
Next, the second copula has to be applied to all subsequent single-period issuer asset returns for each of the
two positions to introduce the autocorrelations (like equation 1.36 and 1.37 in the two-period example). Note
that the two copulas do not actually have to be applied, since it is only required here to express how the issuer
asset returns in each single-period for both positions would be constructed if both copulas were applied. Using
these created copula application expressions, all issuer asset returns in the model have to be written in terms
of independent standard normally distributed random variables (like equation 1.38 and 1.39 in the two-period
setting). Hence, xA,1 , xAAC,2 ,..., xAAC,N and xB ,1 , xBAC,2 ,..., xBAC,N have to be expressed in terms the underlying independent
variables, xA,1 , xA,2 ,..., xA,N and z1 , z2 ,..., zN , where N is the number of periods. From there, all corr( xA,i , xB, j ) ,
corr( xA,i , xA, j ) and corr( xB,i , xB , j ) for i 1,2,..., N and j 1, 2,..., N can be derived in terms of AB , A, AC and
B , AC . Utilizing all those expressions, the correlation between xA,1 xAAC,2 ... xAAC,N and xB ,1 xBAC,2 ... xBAC,N , the
implied issuer correlation, can be derived by expressing the standard correlation formula (equation 1.46) in
terms of AB , A, AC and B , AC .
corr( xA,1 xAAC,2 ... xAAC,N , xB ,1 xBAC,2 ... xBAC,N )
cov( xA,1 xAAC,2 ... xAAC,N , xB ,1 xBAC,2 ... xBAC,N )
var( xA,1 xAAC,2 ... xAAC,N ) var( xB ,1 xBAC,2 ... xBAC,N )
(1.46)
*
For a given required implied issuer correlation, a corrected input issuer correlation coefficient ( AB
) can be
derived, using exactly the same steps as those taken in equation 1.42 and 1.44 (again, the complete procedure
is described in detail for the two period example in appendix A.1). Even though this correction is timeconsuming to derive, its use allows for a complete specification of the implied issuer correlations and the
autocorrelations in this model.34
*
The above procedure ensures that for each pair of positions a corrected input issuer asset correlation ( AB
)
can be computed, using their observed input asset correlation ( AB ) and the autocorrelation coefficients of
both underlying issuers ( A, AC and B , AC ). With these corrected input issuer correlations, issuer asset returns
for each position for each period can be simulated that display the proper issuer asset correlations and the
proper issuer-specific autocorrelations. The actual process that generates the single-period issuer asset returns,
that are required in the credit rating simulation model discussed in section 1.3.1, comprises three steps:
1. The calculation of corrected input issuer asset correlation matrix C* : When the single-period issuer asset returns
are generated for a portfolio with multiple positions, correlation matrix C is known and all
autocorrelations coefficients i , AC (for i 1,..., n ) are known as well. Correlation matrix C contains all
observed issuer asset correlations between the issuers underlying the positions. Using the issuer
correlation coefficients in C and the autocorrelation coefficients, corrected issuer correlations must
be computed. For each pair of positions (or issuers) in the portfolio, a corrected issuer asset
*
correlation coefficient ( AB
) can be calculated with the use of their observed issuer asset correlation
( AB from C ) and the observed autocorrelation coefficients underlying both positions ( A, AC and
B , AC ). All these corrected issuer correlations coefficients together form a corrected issuer correlation
matrix C* that has the same dimensions as original issuer correlation matrix C .
34
When the number of positions in the model is increased, a small effect in the implied correlation between each issuer pair may be
introduced through the web of single-period correlations and autocorrelations of the other issuers. A correction for this effect is
derivable in a way similar to the one presented already. However, because this correction relies on the Cholesky decomposition
matrix, such a formulation of a correction would become extremely large when a substantial number of credit products is
considered. For this reason, this effect is ignored in this study. Moreover, the deviation between the implied issuer correlation in the
model and the input issuer correlation resulting from this effect is mostly extremely small. The largest deviation encountered in the
70 times the model has been estimated in Part III was only 0.06.
39
2. The application of the first copula (in the cross-sectional dimension): The corrected correlation matrix C* is
subsequently used in the generation of the actual issuer asset returns that are required in the
simulation model. Herein, the first step is the application of the first (multivariate) Gaussian copula in
each of the single-periods in the model, where the corrected issuer correlation matrix C* is employed
instead of the observed correlation matrix C . A large number of simulation scenarios must be
generated and, in each scenario in each single-period, the issuer correlations between all simulated
issuer asset returns must be introduced, according to corrected correlation matrix C* .
3. The application of the second copula (in the time-series dimension): The last step is the introduction of issuer
autocorrelations into the system. Herein, the second Gaussian copula (the bivariate Gaussian copula)
is applied multiple times, using each positions (or issuers) own autocorrelation coefficient ( i , AC for
i 1,..., n ). This bivariate copula must be applied in each scenario for each separate positions
subsequent single-period issuer asset returns that have been generated in step 2. Hence, in the fourperiod model, the second periods return must be linked (or correlated) to the first periods return, the
third periods return to the (new) second periods return, and the fourth periods return to the (new)
third periods return. This must be done in each scenario for each single position. As a consequence,
the implied issuer correlations in this structure of correlated issuer asset returns, based on the large
number of generated scenarios, will be equal to those in the original observed correlation matrix C .
The derived correlation structure is of Gaussian nature. Yet, as mentioned earlier, the t-Student model for
credit quality correlation may be a better approximation of reality, especially in terms of downside
dependence. Fortunately, the standard normally distributed issuer asset returns are easily converted to Student
t-distributed issuer asset returns with identical correlation properties.
To achieve this more realistic t-Student model, random 2 -variable s must be generated, with the number of
random drawings equal to the number of simulations in the model and a degrees of freedom ( ) equivalent to
that of the desired t-Student (copula) model. Subsequently, the Gaussian single-period issuer asset returns
( x1 , x2AC ,..., xNAC ) of each position are multiplied by ( / s)1/2 , where s is the equal for each position and each
single-period in a given scenario. As a consequence, the converted simulated asset issuer returns of each
position are Student t-distributed with a degrees of freedom equal to . Obviously, this conversion has to be
implemented for each simulation scenario in the model. Hence, the fact that the length of the s -variable
series should be equal to the number of simulations. The conversion is nothing more than the application of
the last step in the creation of Student t-distributed random variable, as explained in the t-Student copula
section (section 1.4.2). The conversion is employed after all correlations are introduced into simulated issuer
asset returns and therefore all correlation properties of the Gaussian issuer asset returns are still in existence
after the conversion to the Students t-distribution. Consequently, the correlation structure and its corrections
are still valid when it is converted from the Gaussian to the t-Student assumption.
1.4.6 Rebalancing Moments
The last remark on the correlation structure is that not all single-period issuer asset returns for all positions
should be auto-correlated to the previous single-period asset return. When autocorrelation would be
introduced in each period-to-period transition, it would reduce the benefits of rebalancing at the end of the
liquidity horizon. The position must be rebalanced to its initial risk level at the end of the liquidity horizon,
implying that there is no reason to claim that the first single-period issuer return underlying the new
rebalanced position should be auto-correlated to the last issuer return under the old position, as both refer to
different issuers.
This is in contrast with Dunn (2008) who states that autocorrelation in the single autoregressive risk factor
that he proposes is especially important to credit products with short liquidity horizons. He argues that
without the autocorrelation systematic risk could effectively being ignored on such positions. In this study,
however, autocorrelation is removed after the position is rebalanced to reset the risk at these moments. Like
40
in Dunn (2008), autocorrelation is considered as contributing to the risk within the portfolio as well.
Therefore in contrast to Dunn (2008) this component is also part of the risk that requires a reset at
rebalancing moments. Such an application is entirely consistent with the constant risk assumption.
Consequently, in the four-period model, single-period issuer asset returns of positions with a liquidity horizon
of three months should contain no autocorrelation. The issuer asset returns of positions with a liquidity
horizon of six months should not exhibit autocorrelation from period two to period three. In the case that the
liquidity horizon is nine months there should be no autocorrelation from period three to period four and for
positions with a liquidity horizon of one year all single-period issuer asset returns should be auto-correlated.
Lastly, in case of a default, no autocorrelation with regard to the next periods return should be incorporated
as well. All these conditions must be incorporated into the second copula application (step 3 in the generation
of the single-period issuer asset returns). The equation of the second Gaussian copula (equation 1.33), the
bivariate copula in the time-series dimension, is modified into:
xiAC
1 I t k i2, AC xi ,t k for k 6,9,12 and i 1,2,..., n ,
,t k I t k i , AC xi ,t k 3
where I t k ,i
(1.47)
1 if CRt k 3,i D and k 3 qi h
0 if CRt k 3,i D
.
0 if k 3 q h for h 1,2,3,4
i
Variable Itk is an indicator variable that holds the value of zero when rebalancing occurs at time t k and
holds the value of one when no-rebalancing occurs. Consequently, the copula is only applied when no
rebalancing occurs, as when rebalancing does occur the equation simplifies to: xiAC
,t k xi ,t k .
Note that this alteration of the implementation of the second copula ensures that the issuer correlation
correction not valid anymore when rebalancing of the position of one of the relevant issuers occurs in any of
the periods. This complication is accounted for by setting the autocorrelation coefficients underlying the
positions with a liquidity horizon of three months to the value of zero, in the calculation of the corrected
issuer corrections in matrix C* ( i , AC 0 if qi 3 , for i 1,..., n ). For the remaining issuer correlations no
alteration is imposed to the correction, resulting in slightly too high total return issuer correlations in the
model for these positions. This complication is ignored, due to the fact that the resulting bias is extremely
small and the fact that the derivation of a correction would be extremely time-consuming, as it would lead to a
correction formula that is many times larger than the four-period model issuer correlation correction
presented as equation 1.45.
With these last specifications in place, the derivation of the correlation structure of the proposed incremental
risk model is complete. The result is that the asset correlations between all issuers underlying the positions can
be specified in detail (i.e. each correlation coefficient can take on a unique pre-specified value). Consequently,
directly estimated historical correlations can be inserted into the model as well as correlations estimated with
commonly applied factor models.35 This feature of the constructed correlation structure makes it much more
versatile than the often used bivariate Gaussian specification of systematic and idiosyncratic risk. Moreover,
Zeng & Zhang (2001) have shown that these single-factor correlation structures, as applied by Dunn (2008)
for example, often perform worst than the simple use of historical correlations.
The correlation structure will be used in the model estimations in Part III and its issuer correlation and
autocorrelation inputs are estimated in Part II section 2.2. One final remark is that the complete correlation
structure, as presented in this section, is completely interchangeable. The simulation model does not
exclusively dependent of this specific structure. Any correlation structure can be combined with the
constructed credit rating simulation model as long as the required asset return thresholds (Z-values) can be
computed, with the use the assumed distribution of the underlying issuer asset returns in this structure.
35
Zeng & Zhang (2001) provide an extensive assessment of various asset correlation factor models and historical directly observed
correlation estimates.
41
PART II
INPUT ESTIMATION
42
The incremental risk model that has been

constructed in Part I is built upon various
inputs. In fact, nearly every incremental risk
model will be built on similar inputs.
Consequently, it would be prudent to discuss
various alternative methodologies that can be
applied in the estimation of these input
parameters as well. Such a set-up generates the
opportunity of an assessment of the effects of
alternative input estimation methodologies on the
output of the proposed model. Herein, the
emphasis is entirely placed on the two most
imperative inputs of the model: the stand-alone
risk specification (the credit migration matrix)
and the specification of the relations between the
migration and default risk underlying the
various individual positions in the portfolio (the
issuer correlations and autocorrelations). First,
in section 2.1, three alternative techniques
concerning the estimation of the credit migration
matrix are addressed, and the underlying
conditionality of this matrix is treated as well.
Secondly, in section 2.2, the estimation of issuer
asset return correlations is discussed. In this, the
two main approaches on this subject, the equity
correlation proxy and issuer asset correlation
based on default rates, are evaluated.
Subsequently, in the last section of Part II,
section 2.3, three corporate bond portfolios are
constructed. These bond portfolios are required to
perform the model estimations in Part III and
are obviously inputs of a completely different
nature as the other two. In essence, realistic
portfolios are required to ensure that a useful
model assessment can be set forth in Part III.
Hence, the formation of these portfolios will be
discussed in detail.
2.1
CREDIT MIGRATION MATRICES

The credit migration matrix serves as the primary input in the model. In essence, the credit migration matrix is
the specification of magnitude of the default and migration risk for any individual credit product in the model.
The entries in the matrix denote what likelihood is for an underlying issuer of a credit product, given its initial
credit rating, to migration to another credit rating or the default state in a pre-specified time horizon. In the
proposed incremental risk model that horizon is three months, consistent with the length of a single-period in
the credit rating simulation model (see Part I section 1.3.1). Various methodologies exist in the estimation of
the credit migration matrix. The estimation results can vary substantially, depending on the methodology that
is applied to estimate it. Hence, in this study three different methodologies will be employed to estimate the
matrix. An assessment of the differences that these methodologies generate in the eventual output of the
incremental risk model, the 99.9% value-at-risk measure, will be presented in Part III section 3.1.1.
2.1.1 Standard & Poors Credit Ratings Data

To understand the methodologies that will be employed to estimate credit migration matrices, one first has to
evaluate the required underlying data. The estimation of credit migration matrices relies in general on the
historical credit ratings and migrations of all issuers in the relevant issuer spectrum. Basically, historical
migration data is utilized to generate the probabilities of these events occurring again. In that context, the
issuer spectrum rated by Standard & Poors is used in this study. More specifically, the long-term, local
currency issuer ratings for US issuers, as provided by Standard & Poors, are used. Accordingly, a database of
the S&P ratings of all US issuers is reconstructed, using all Rating Changes information from Bloomberg
Professional in the long-term, local currency, US issuer category. The start of the database is set to
01/01/1980 and the last date in the database is 28/04/2009.
In the construction of the database, several adjustments are required to ensure that the credit ratings data is
tailored to comply with the needs of the credit migration matrix estimators. First of all, all credit ratings are
stripped of additional credit quality modifiers, implying that all (+) and (-), credit watch and public
information identifiers are removed. Subsequently, ratings CCC, CC and C are combined into one single class
(CCC/C). Both adjustments are very common in the literature and are employed to ensure that the number of
issuers within a particular rating class is large enough to produce meaningful migration probability estimates.
The adjustments reduce the number of credit ratings in the matrix from 25 to 9 (including the Not Rated
NR-category), resulting in a decline in the number of parameters (migration probabilities) to be estimated
from 625 to 81, whereas the number of useful observations only suffers 50% reduction.
In addition, issuers that are rated R (Regulatory supervision) at some point in time are added to NR-category
during the time they held the R rating. This adjustment is employed, since the true nature of why the issuer
was rated R is not known. Adding them to another rating class might bias the migration probability estimates,
whereas treating them as NR-rated ensures that these ratings are only non-informative at the time the issuer
holds the R rating. Moreover, the total number issuers that were rated R at some point in time in the database
was incredibly small (only 96), resulting in a very limited loss of potentially useful information.36
In the treatment of default, the ratings SD (Selected Default) and D (Default) are grouped together under the
D rating class, which is common in the literature as well. Issuers that default, then migrate to NR and then
migrate back to a rated class, as in a non-NR credit rating, are treated as new issuers from the point they
migrate from NR to the rated rating class again. Issuers that experience a default and then migrate at once to
36
Numerous other studies add the R rating to the default category. In this study, the decision is made to treat them as noninformative and limit the default definition to default (D) and selective default (SD). The result is that the default rates presented in
this study might be slightly lower than those in other studies using similar Standard & Poors data.
43
another rated rating class are treated as new issuers from the point this migration occurs. Finally, migrations
from D to NR are removed from the sample. This adjustment ensures that the default state is absorbing. The
total number of defaults in the database is 811 and the total number of issuers is 7394. Moreover, the total
number is rated issuer years in the (29.33 year) database is 68,595.26 (including the absorbing default state).
Lastly, to constructed data-series with a convenient month/year relation, the last Sunday of May, July, August,
October and December are removed for each year in the sample period and in leap-years the last Sunday of
March is removed as well. Consequently, each year has 360 days and when these 360 days are divided in 12
blocks of 30 days nearly every month is correctly displayed.37
2.1.2 The Cohort Method
As mentioned, the estimation of credit migration matrices relies in general on the historical ratings and
migrations of all issuers in the relevant issuer spectrum. The first approach, the cohort method, is quite
straightforward and has become the industry standard in the estimation of credit migration matrices. It is
employed, for instance, by Moodys in the calculation of migration probabilities in the matrices that they
present in their publications (e.g. Emery et al., 2009). Christensen et al. (2004) provide an excellent description
of the methodology. It employs a discrete-time setting or more specifically, it is the estimation of a discretetime Markov chain. The method is based on the fact that the migrations away from a given state i (or rating
i ) can be viewed as a multinomial experiment. The number of issuers in state i at the beginning of period t
is defined as Ni (t ) and the number of issuers with rating i at time t that are in state j at time t 1 (one year
later for example), is defined as Nij (t ) . Then when rating withdrawals (the NR state) are disregarded, the
estimate of a one-year credit migration probability at time t is simply calculated as follows:
p ij (t )
N ij (t )
.
N i (t )
(2.1)
In case the rating process is viewed as a time-homogeneous Markov chain which is observed over time, then
the migrations away from a state can be seen as independent multinomial experiments. This assumption
ensures that all observations over different years can be combined into one data set. The maximum-likelihood
estimator for the time-independent migration probability becomes:
T 1
p ij (t )
ij
t 0
T 1
(t )
N (t )
(2.2)
t 0
In this equation, T is the number of periods (cohorts) included in the data set. In a special case, when the
number of issuers in a rating class remains the equal (the inflow into the rating state is equal to the outflow
from the rating state), the migration probability estimator is the average of the two single cohort migration
probabilities. This average, however, only serves as an approximation when the number of issuers in a
particular rating class changes. The presented estimator (equation 2.2) correctly weights the migration
information according to the number of issuers observed in the particular rating class each period. This
weighing scheme is known as the issuer-weighted average.
The assumption of time-homogeneity is applied in the estimator to be able to aggregate migrations and
exposures over different time periods. If the assumption is not made, the estimator of the probability of a
migration from rating i to rating j over a particular time period t to T is:
p ij (t )
37
Nij (t , T )
,
Ni (t )
(2.3)
The result is similar to the 30/360 convention. Furthermore, the effect of the deleted Sundays in the estimation of the credit
migration matrices is negligible.
44
where Nij (t , T ) is the total number of observed migrations from i to j in that particular time period,
t to T .
This is the cohort estimator, which is a multinomial type estimator as well. It can even be interpreted as such
without the Markov assumption.38
The first disadvantage of cohort method, however, is that when no migration events for a particular migration
are observed between time t and time T , the estimate will be equal to zero. In practice, this will result in
default probability estimates that are equal to zero for the highest credit ratings (AAA and AA), as jumps to
default from those rating classes are observed very rarely.39
The second problem of the approach is that when an issuer migrates from rating i to rating j to rating k ,
within time period t to T , the first migration (from i to j ) will be ignored, as the estimator only captures
the migration from i to k (the migration from the state at start of the period, time t , to the state at the end
of the period, time T ). As a consequence, information is left unused which may result in underestimated
migration probabilities. In practice, issuers frequently migrate to the CCC/C category (CCC, CC or C) first
before they actually default. Then when the migration to the CCC/C category is ignored, it will result in a
CCC/C to default migration probability that is biased downwards (Lando & Skdeberg, 2002).
2.1.3 The Duration Method
The second credit migration matrix estimation methodology is the duration method. This estimation
methodology is based on continuous-time observations and was initially presented in Jarrow et al. (1997). It
addresses most of the shortcomings on the cohort estimator. The continuous-time framework is based on
modern survival analytic techniques (Skdeberg, 1998). Lando & Skdeberg (2002) argue that is crucial to base
estimates of migration probabilities on continues-time observations to obtain efficient estimates of migration
probabilities. In addition, they summarize the key advantages of the duration approach:
1. Non-zero estimates for migration probabilities of which no events where observed.
2. The estimates rely on a generator matrix (discussed below) and with this single matrix migration
matrices for any migration horizon can be computed.
3. The estimator uses all possible data. Each migration is taken into account, even if the issuer only
spends a single day in the particular rating state.
4. The framework allows for rigorous formulation and testing of assumptions. Rating drift and other
non-Markov type behaviour can be addressed.
5. The dependence of the migration probabilities on external (macroeconomic) covariates can be
formulated and tested, and changes in regimes due to business cycle effects (as in Nickell et al., 2000)
or due to changes in rating policies (as in Blume et al., 1998) can be assessed.
6. The Not Rated (NR) category is handled very easily in the continuous-time framework. Carty (1997)
argues that only 13% of the migrations to NR are related to changes in credit quality, and there and in
Nickell et al. (2000) this argument is used to exclude issuers who experience a transition to the NR
category. In the continuous-time framework, such observations can be censored, allowing for full use
of the information in the sample. The time an issuer spends in a rating category before it migrates to
NR is valuable information on the transitions that did not occur in that time period. In contrast, in the
cohort approach, basically all issuers that are rated NR at the beginning or the end of each estimation
interval are treated as non-informative and are implicitly eliminated from the sample.
38
39
The standard errors of the migration probabilities resulting from the cohort estimator can be calculated relatively simply under the
assumption that the rating migrations are temporally and cross-sectionally independent. If one considers the binomial variable:
starting in state i and either migrate the state j or k 1,..., K where k j , then the standard error for p ij can be calculated as a
standard binomial standard error (Nickell et al., 2000): sij ( p ij (1 p ij ) / Ni )1/2 , where Ni is the number of issuers in state i at time t
(equivalent to the number of experiments in the binomial setting).
None are observed in the Standard & Poors data set.
45
As mentioned above, the estimation based on continuous observations relies on a generator matrix. More
specifically, it relies on the estimation of the generator matrix of a time-homogeneous Markov chain. The
credit migration probability matrix, of a continuous-time Markov chain with finite space S {1, 2,..., K} , is
denoted as P (t ) , where t is the considered migration or risk horizon. Thus, the ij th element of this matrix is:
Pij (t ) P(t j | 0 i) .
(2.4)
The generator matrix ( ) is a K x K matrix from which P (t ) can be calculated as follows for all t 0 :
P(t ) exp(t ) ,
(2.5)
where exp(t )
k 0
(t )
.
k!
k
The entries in the generator ( ) satisfy:

ij 0 for i j ,
(2.6)
ii ij .
(2.7)
These entries describe the probabilistic behaviour of the holding time in rating state i as exponentially
distributed with parameter i , where i ii , and the probability of jumping from rating state i to rating
state j in the case that a jump occurs is given by ij / i . The maximum-likelihood estimator for the
calculation of the elements of the generator matrix under the assumption of time-homogeneity is expressed as
follows (Kchler & Srensen, 1997):
ij
N ij (T )
T
(2.8)
Yi (s)ds
0
where Yi ( s) is the number of issuers in state i at time s and Nij (T ) is the number of migrations from
state i to j over the entire estimation period ( T ), where i j .
The numerator counts the number of migrations, from rating state i to j , that occur in the entire time
period or sample period ( T ). The denominator effectively counts the number of issuer years spent in rating
state i during the entire time period ( T ). Any amount of time any issuer spends in a particular rating class will
be accounted for through the denominator. Consequently, all (duration) information in the entire sample
period is taken into account. The approach is time-homogeneous, since the assumption is made that ij is
stable over time.
A disadvantage of the duration approach is that confidence bands or standard errors for the migration
probabilities are unusually hard to estimate. Christensen et al. (2004) argue that the calculation of the standard
error of a migration probability as a simple binominal standard deviation, like in the cohort estimation
methodology, is inefficient and present a bootstrap experiment to compute confidence intervals. The
bootstrap experiment involves the construction of fake datasets and is extremely time-consuming, as the
specific characteristics of the underlying data set, which is exceptionally large in the estimation of credit
migration matrices (see section 2.1.1), must be reflected in these fake datasets. Christensen et al. (2004)
produce 500 of these fake datasets to effectively estimate their confidence bands. In essence, the exercise
performed by Christensen et al. (2004) demonstrates that it is difficult to compute efficient measures of
estimate uncertainty in the duration method, making statistical inference incredibly time-consuming.
2.1.4 The Aalen-Johansen Estimator
The third migration matrix estimation methodology is based on the Aalen-Johansen estimator, which is a nonparametric non-homogeneous estimation approach (Aalen & Johansen, 1978). Time-homogeneity is an
46
assumption that is hard to make over long periods of time. The Aalen-Johansen estimator is nonhomogeneous and may therefore be a useful approach to replace the cohort method over longer periods of
time (Lando & Skdeberg, 2002).
Consider a non-homogeneous, continuous-time Markov process with finite state space S {1, 2,..., K} of
which the migration probability matrix, from time s to time t , is given by P( s, t ) . The ij th -element of the
matrix ( Pij (s, t ) ) describes the probability that the chain starting in state i at time s is in state j at time t :
Pij (s, t ) P(t j | s i) for s t .
(2.9)
Credit migration matrix P( s, t ) can be estimated with the Aalen-Johansen estimator which is commonly
referred to as product-limit estimator as well. Given that the sample contains m migrations over period s to
t , P( s, t ) can be estimated consistently as:
m
(Ti )] .
P ( s, t ) [I A
(2.10)
i 1
In this equation, Ti is a jump in time in period s to t , I is the identity-matrix with dimension K x K and
(Ti ) can be estimated as follows:
A
N1 (Ti )
Y1 (Ti )
N 21 (Ti )
(Ti ) Y2 (Ti )
A
N p1,1 (Ti )
Yp1 (Ti )
N12 (Ti )
Y1 (Ti )
N13 (Ti )
Y1 (Ti )
N 2 (Ti )
Y2 (Ti )
N 23 (Ti )
Y2 (Ti )
N p1,2 (Ti )
Yp1 (Ti )
0
N1 p (Ti )
Y1 (Ti )
N 2 p (Ti )
Y2 (Ti )
N p1 (Ti )
Yp1 (Ti )
N p1,1 (Ti )
Yp1 (Ti )
(2.11)
where Nhj (Ti ) denotes the number of migrations from state h to state j on moment or date Ti ,
Nk (Ti ) denotes the number of migrations away from state k at moment or date Ti and Yk (Ti ) counts
the number of issuers in the state k right before moment Ti .
Hence, the diagonal element in row k counts the fraction of exposed issuers ( Yk (Ti ) ), right before moment Ti
that leaves state k at moment Ti . Lando & Skdeberg (2002) explain that the notation Nhj (Ti ) is used to
avoid mistaking this variable for the one applied in the cohort method. Variable Nhj (Ti ) becomes equivalent
to a one-day cohort variable ( Nij (t ) ) when the migration data sample has a frequency of one day, as is the case
in this study and in most other research in which this estimator is employed. Herein, moment Ti becomes an
explicit date and therefore the Aalen-Johansen estimator may then be seen as an estimator that is built on
cohort estimators for a time intervals of one day. The 1 to m multiplication-range in the equation 2.10, that
normally multiplies A (Ti ) for all migrations in the sample, in this case becomes a multiplication of A (Ti )
for all days in the sample. Due to the large number of data-points (days and migrations), the effects of the
modification are certainly only marginal.
In the treatment of the NR state in all three migration matrix estimation methods, the NR category is included
in the estimation, but removed again by distributing the probability of migrating from rating i to NR amongst
all states in proportion to their probability values. This method is common in the literature and effectively
treats the NR category as non-informative, while the issuer duration information of before migrating to NR or
after migrating away from NR is still used in the estimation of the migration matrix in the duration approach.
As mentioned, for the estimation with the cohort approach, it implicitly results in removing the issuer for the
(sub)sample during the estimation period. The Aalen-Johansen estimator automatically incorporates
censoring and therefore, optimally uses the available information.
2.1.5 Results and Comparison
47
All three estimation methods are employed to estimate the required credit migration matrices. As mentioned
in section 2.1.1, the used dataset is the historical issuer ratings for all US companies rated by Standard &
Poors. The applied estimation period is 28/04/1989 28/04/2009, which is exactly 20 years and ends at the
point in time at which the last Rating Changes observations were taken from Bloomberg Professional. The
migration horizon that is assessed is the three-month horizon, since the length of a single-period in the
proposed incremental risk model is three months. For the cohort method, the matrix is based on equation 2.2,
which results in an issuer-weighted average of the 40 underlying three-month migration matrices (40 cohorts
of three months). The estimated cohort method migration matrix is displayed in the table I. The three-month
duration method migration matrix is based directly on the entire 20 year sample, since no aggregation of subsample matrices is required. The estimation result of the duration approach is shown in table II. The third
approach, the non-homogeneous Aalen-Johansen estimator, is like the cohort method computed with the use
of 40 three-month sub-sample migration matrices. Once more, an issuer-weighted average is employed. The
three-month Aalen-Johansen migration matrix is displayed in table III.
First of all, it is important to note that the three matrices all exhibit the distinctive characteristics of credit
migration matrices as described in Bangia et al. (2002). Monotonicity,40 however, is violated in all three
matrices in (and around41) two entries: AAA to CCC/C and CCC/C to AAA. Two issuers in the sample were
downgraded from AAA to CC (both Lehman Brothers entities) and one issuer was upgraded from CCC to
AAA. These observations are considered to be extreme events and (may) have resulted in too high estimated
probabilities with respect to the occurrences these events.
Besides the obvious similarities between the three matrices, differences are apparent as well. The first essential
difference when one compares the results of the different estimation methodologies, can be found when the
probability of migrating from CCC/C to D ( pCCCD ) is examined. As anticipated, the cohort method has
generated an estimate that is substantially lower than those generated with the two continuous-time methods.
Its value is more than 2% lower in both cases, which is a considerable difference on a three-month migration
horizon. In contrast to the CCC/C default probability, when the default probabilities for ratings B, BB, BBB
and A are examined, it becomes apparent that here the cohort method produces substantially higher estimates.
This result is a side effect of the drawback of the cohort method to only account for the net migration result,
when two migration events for a single issuer occur within one cohort. As a result of not completely capturing
all migrations, the cohort estimator implicitly assigns too large weights to the migrations that it does capture.
A third key difference between the matrices is the probability of migrating from AAA to D ( pAAAD ). None of
the AAA-issuers has experienced a jump to default in the dataset, which resulted in an estimate equal to zero
for the cohort method. Obviously a AAA-issuer can default and consequently, the cohort method estimation
results are biased once more. The duration and Aalen-Johansen estimators do produce above zero estimates
and thus, generate the required assessment of the default risk of a AAA-issuer.
TABLE I - Credit Migration Matrix: Cohort Method
AAA
AA
A
BBB
BB
B
40
41
Estimation period: 28/04/1989 28/04/2009

AAA
AA
A
BBB
0.977827
0.020557
0.001155
0.000000
0.001445
0.974983
0.022586
0.000846
0.000285
0.005177
0.980382
0.013118
0.000035
0.000497
0.008108
0.978213
0.000084
0.000281
0.000646
0.012380
0.000026
0.000079
0.000602
0.000419
BB
0.000231
0.000070
0.000687
0.011479
0.960138
0.014104
B
0.000000
0.000070
0.000134
0.001242
0.023608
0.957426
CCC/C
0.000231
0.000000
0.000117
0.000213
0.002162
0.020620
D
0.000000
0.000000
0.000101
0.000213
0.000702
0.006725
Monotonicity is a rule that implies that the further the cell is away from the diagonal, the lower its value, thus the smaller the
likelihood of an occurrence of such an event (Gupton et al., 1997).
For the duration method and Aalen-Johansen estimator the neighbouring cells are affected as well.
48
CCC/C
D
0.000202
0.000000
0.000000
0.000000
0.000405
0.000000
0.001012
0.000000
0.002430
0.000000
0.034825
0.000000
0.865762
0.000000
0.095363
1.000000
The migration probabilities are based on a three-month horizon. The migration probability matrix is computed as an issuer-weighted average of the
40 underlying three-month migration matrices, which are estimated with the cohort estimator. The length of the sample period is 20 years.
TABLE II Credit Migration Matrix: Duration Method
AAA
AA
A
BBB
BB
B
CCC/C
D

AAA
AA
A
BBB
0.978094
0.020264
0.001144
0.000027
0.001404
0.974417
0.023056
0.001026
0.000298
0.005051
0.980022
0.013563
0.000039
0.000545
0.008074
0.977274
0.000086
0.000343
0.000843
0.012058
0.000033
0.000098
0.000770
0.000693
0.000188
0.000047
0.000452
0.001176
0.000000
0.000000
0.000000
0.000000
BB
0.000230
0.000032
0.000887
0.012691
0.959084
0.013409
0.002402
0.000000
B
0.000020
0.000028
0.000140
0.001178
0.025385
0.957042
0.032969
0.000000
CCC/C
0.000206
0.000034
0.000021
0.000153
0.001863
0.023996
0.841919
0.000000
D
0.000014
0.000003
0.000019
0.000047
0.000339
0.003959
0.120847
1.000000
The migration probabilities are based on a three-month horizon. The migration probability matrix is computed with the use of the single sample with
a length of 20 years and is calibrated to display a migration horizon of three months.
TABLE III - Credit Migration Matrix: Aalen-Johansen Estimator
AAA
AA
A
BBB
BB
B
CCC/C
D

AAA
AA
A
BBB
0.978445
0.019827
0.001207
0.000027
0.001399
0.974821
0.022552
0.001098
0.000302
0.005064
0.980029
0.013491
0.000039
0.000547
0.008073
0.977326
0.000083
0.000335
0.000850
0.012107
0.000029
0.000095
0.000772
0.000700
0.000181
0.000048
0.000436
0.001175
0.000000
0.000000
0.000000
0.000000
BB
0.000233
0.000050
0.000911
0.012593
0.959302
0.013436
0.002522
0.000000
B
0.000036
0.000042
0.000158
0.001211
0.025039
0.957167
0.033121
0.000000
CCC/C
0.000215
0.000037
0.000025
0.000163
0.001881
0.023292
0.845049
0.000000
D
0.000010
0.000001
0.000019
0.000048
0.000402
0.004510
0.117468
1.000000
The migration probabilities are based on a three-month horizon. The migration probability matrix is computed as an issuer-weighted average of the
40 underlying three-month migration matrices, which are estimated with the Aalen-Johansen estimator. The sample period is 20 years.
In the comparison of the duration migration matrix (table II) and the Aalen-Johansen migration matrix (table
III), it is apparent that both matrices are remarkably similar. This is completely in line with what is observed in
the literature (e.g. Lando & Skdeberg, 2002; Jafry & Schuermann, 2004). The difference between both
estimators is the time-homogeneity assumption underlying the duration methodology. The fact that both
matrices are alike demonstrates that for a three-month horizon, the time-homogeneity assumption has no
large effect. Moreover, the Aalen-Johansen matrix is not completely non-homogeneous, as the issuer-weighted
average brings back some elements of time-homogeneity in the methodology. Nonetheless, the nonparametric Aalen-Johansen matrix does to some extent confirm that at short horizons the time-homogeneity
assumption can be made. For longer periods, however, the assumption is unrealistic and time-inhomogeneities
should become apparent. This is backed by the fact that a completely non-homogeneous 20-year AalenJohansen migration matrix, based on the single 20 year sample, differs considerably from the (scaled) matrix
resulting from the duration method (both matrices are not shown). Moreover, Kleindiek (2005) presents
statistical evidence for time-invariance regarding migration probabilities based on long sample periods.
Consequently, all three matrices can only be seen as unconditional estimates that are only valid on average.
The effects of macroeconomic shocks and other disturbances are not taken into account. In the duration
method, however, the sources of these time-inhomogeneities and other deviations from the standard Markov
49
assumption set can be addressed by working with migration intensities ( ij ). Such an assessment is impossible
in the application of the cohort estimator or Aalen-Johansen estimator.42 This possibility, its convenient
scalability and the fact that the duration migration matrix is much easier to compute than the Aalen-Johansen
migration matrix, makes the duration approach the preferred method in the recent literature.
2.1.6 Conditional Credit Migration Matrices
The next step is to focus on time-invariance in the migration matrices. The three matrices presented in the
previous section can be defined as unconditional matrices, since they are unconditional (average) estimates
that are based on relatively long periods of time. Thus, a logical next step would be to condition the migration
matrix on covariates (conditions) that might influence the migration probabilities. Such a setting would
address the time-inhomogeneities in the migration matrix, thereby producing conditional probability estimates.
This is exactly what recent literature has been focusing on.
One of the first appearances of this subject in the literature is found in Nickell et al. (2000). They employ
ordered probit models and attempt to quantify the dependence of rating migration probabilities on industry
and domicile of the issuer and on the stage of the business cycles. Kavvathas (2001) utilizes the duration
approach to examine the variation in the likelihood of credit migrations over the business cycle and also
investigates the effects of non-Markovian behaviour such as rating drift. The conditioning of the migration
matrix on stages of the business cycle is performed by Bangia et al. (2002) as well. In addition, similar to
Kavvathas (2001), Lando & Skdeberg (2002) use a multiplicative hazard model in their continuous-time
framework to assess the presence of rating drift in credit migration dynamics. Gttler (2006) follows a similar
approach and focuses on rating drift as well. As an extension to the continuous-time duration methodology,
Christensen et al. (2004) introduce hidden Markov chains in the model as an attempt to capture rating drift.
Moreover, Jafry & Schuermann (2004) investigate the effects of conditioning migration matrices on the stage
of the business cycle once more and Figlewski et al. (2008) utilize the migration intensities underlying the
duration approach to examine whether firm-specific variables (addressing rating drift) and macroeconomic
variables influence migration probabilities. Lastly, Frydman & Schuermann (2008) model the non-Markov
rating drift property found in rating migrations by employing Markov mixture models and also take into
account the industry of the issuers and the stage of the business cycle in the conditioning of their model.
The fundamental conclusions to be drawn from the abovementioned body of research are unambiguous.
Rating drift is the most pronounced non-Markovian factor that one would have to account for in a credit
migration matrix or model. All mentioned studies that assess this subject find a significant influence of the
rating drift concept in their model or find an increase in the forecasting performance of their model if
forecasting is actually performed. These findings are independent of whichever type of model is employed.43
Secondly, the stage of the business cycle and more specific macroeconomic variables provide a significant
influence in rating migration probabilities as well in nearly all cases.44 Lastly, issuer domicile and industry,
though not often tested, may also enhance the accuracy of a credit migration model.
The incremental risk model proposed in this study does consider some of these factors. First of all, the
constructed S&P dataset is comprised of only US issuers and only corporate bonds from US issuers will be
considered in the portfolios that are inserted into the model. This model simplification has the benefit of
conditioning on issuer domicile in the estimation of migration matrices and therefore the risk underlying those
42
43
44
One can condition the sample underlying the cohort estimator or the Aalen-Johansen estimator to specific events but there is no
way to formulate hypotheses on the resulting conditional estimates with respect to the unconditional estimates.
Notice that these conclusions create strong reasons to incorporate autocorrelation in the correlation structure of the simulation
model, since rating drift is effectively introduced into the simulation model when positive autocorrelation is inserted.
See Kavvathas (2001) and Figlewski et al. (2008) for an extensive assessment of which macroeconomic variables affect credit rating
migration probabilities or the underlying intensities.
50
portfolios is specified in more detail. Secondly, autocorrelation is incorporated into the proposed incremental
risk model, which effectively introduces rating drift in the simulation.
Lastly, in the light of the numerous the findings concerning the stage of the business cycle, one additional
conditional credit migration matrix is estimated. This matrix is conditioned to the recent credit crisis and
estimated with the duration methodology. The estimation of such a matrix also allows for a more detailed
examination of migration/default correlation, as increased correlations should be captured (at least partially)
by the matrix, since it is based on averages during the credit crisis period.45 A comparison of the output of the
proposed incremental risk model, with the conditional migration matrix as input and relatively low issuer asset
correlations, to that of the same model, with the unconditional duration method matrix and a correlation
structure calibrated to the credit crisis, may shed light on the extent to which a conditional migration matrix
can capture migration/default correlation. In this section, the estimated conditional matrix is discussed and in
Part III section 3.1.1 and 3.1.2 its implications with respect to the incremental risk model are examined.
The conditional credit crisis migration matrix is shown in table IV and is estimated with the duration
methodology. The applied estimation period is 30/07/2007 28/04/2009, as the implosion of Bear Stearns
hedge funds is assumed to be the first real sign of the upcoming financial crisis.46 The end of the estimation
period is set to the end of the complete sample or database, as one cannot assume the crisis to have ended at
that point in time. Notice that the time-homogeneity assumption is much easier to make for this relatively
short sample period of 21 months. Hence, the duration estimator should be relatively unbiased.
Table IV displays the credit migration matrix conditional to the credit crisis. The first difference of the
conditional matrix compared the unconditional duration method migration matrix (table II) that is worth
emphasizing is the decrease in all the elements of the diagonal or the no migration probabilities (except for
the BBB-rating). The average decrease in these probabilities is approximately 3% and signals, obviously, that
credit ratings were less stable during the crisis. Migrations were more likely to occur and this translated in
substantially more downside migration risk, as the probabilities on the right of the diagonal, which represent
downgrades, increased in 25 of the 28 entries. On the other side of the diagonal, the probabilities that
represent the upgrades decreased in 17 of the 20 cases (ignoring the default row), which signals much less
upside potential during the credit crisis. As one would expect, the downside migration risk increased
substantially during the period of crisis. The most apparent example here is the default probability of CCC/Crated issuers that increased by more than 5%, which is approximately 12% when a migration horizon of one
year is considered. Further implications of the conditional credit crisis migration matrix as well as the three
unconditional migration matrices, however, will be discussed in Part III section 3.1.1, in the context of the
actual estimation of the proposed incremental risk model and its resulting value-at-risk measures.
TABLE IV - Conditional Credit Migration Matrix: Duration Method
AAA
AA
A
BBB
45
46

AAA
AA
A
BBB
0.938971
0.050676
0.005079
0.000083
0.000697
0.936675
0.060882
0.001611
0.000004
0.007708
0.971976
0.017196
0.000001
0.000976
0.006708
0.977296
BB
0.001697
0.000091
0.002529
0.013886
B
0.000110
0.000023
0.000242
0.000935
CCC/C
0.003076
0.000014
0.000164
0.000178
D
0.000308
0.000006
0.000183
0.000020
More specifically, the duration approach is based on the average of migrations per issuer year (equation 2.8). Furthermore, increased
correlations or issuer correlations in general affect the migration probabilities. The large difference between the conditional and
unconditional migration matrices (table II and table IV, respectively) may be partially explained by increased correlations.
It was actually in the week of 17 July 2007 that Bear Stearns announced that two of their hedge funds had imploded. The US market
reacted as the volatility of the S&P500 increased from a quite stable low level to a considerably higher new level and moved up and
down around this level until the collapse of Lehman Brothers. Moreover, the Basel Committee and FSA both acknowledge that the
crisis started in the middle of 2007 (BCBS, 2009a; FSA, 2009). The start of the sample is moved up to 30 July to ensure that the
estimation period is equal to exactly seven quarters.
51
BB
B
CCC/C
D
0.000001
0.000002
0.000003
0.000000
0.000501
0.000033
0.000053
0.000000
0.000554
0.000191
0.000044
0.000000
0.011310
0.000074
0.000027
0.000000
0.944866
0.009742
0.000194
0.000000
0.040132
0.944632
0.031800
0.000000
0.002160
0.039214
0.795621
0.000000
0.000476
0.006113
0.172258
1.000000
The migration probabilities are based on a three-month horizon. The sample period is 21 months. The migration probability matrix is computed with
the use of the single sample of 21 months and is calibrated to display a migration horizon of three months.
2.2
ISSUER CORRELATION AND AUTOCORRELATION
The issuer asset correlations in the model serve the purpose of the quantification of the relations between the
stand-alone risks of the individual positions in the portfolio. Equivalently, the issuer asset autocorrelations
quantify the degree of dependence in the time-series dimension. Herein, difficulties emerge, however, since
the asset returns, on which these correlations are based, are not readily observable in financial markets. Hence,
multiple approaches have been developed to address this issue. Gupton et al. (1997) argue that equity
correlations may provide a good proxy for unobserved asset dependency, since equity prices of a company
have a strong and direct connection with the value of its assets. Nevertheless, the use of equity correlations is
not the only methodology to approach unobserved issuer asset correlations. Numerous alternative estimation
methods of the relation between migrations and defaults of companies have surfaced in recent years.
This section contains the details of the two most commonly applied methods in the modelling of migration
and default correlation. First, the equity correlation proxy is addressed. Subsequently, the estimation of issuer
credit quality correlations with the use of observed default data is discussed. The literature may provide many
more and perhaps better ways to address issuer correlations, yet almost every approach finds its origin in one
of the two mentioned here. Consequently, in this study the emphasis in the estimation of issuer correlation is
entirely directed towards these two main approaches.
2.2.1 Equity Return Correlation
The most convenient approach to assess the issuer asset correlations is the application of equity return
correlations. Equity returns are observable market data which have a strong theoretical relation with the asset
returns of a company, i.e. the Merton model. In this sense, credit spreads from the bond market and credit
default swaps market also provide market data where issuer asset correlation estimates can be based upon.
However, the equity universe is considerable larger than these markets and in these markets data quality and
illiquidity are concerns as well. Consequently, the largest advantages of the equity return proxy approach are
that all required data is widely available, it comes from liquid markets and is good of quality. An additional
advantage is that the correlation estimates can be based on information at the issuer level. No clusters of
issuers have to be constructed since equity return information is available for almost every single issuer.
The major disadvantage of the equity proxy is addressed in De Servigny & Renault (2003). They argue that
equity prices and returns reflect many factors, such as changes in risk aversion in the equity markets and
liquidity effects and that a substantial proportion of these changes may not be related to the financial stability
of the issuers. They present empirical evidence that implies that default correlation implied by equity prices
does not perform very well in explaining observed default correlation. Nonetheless, the general evidence on
the subject is mixed. Dllmann et al. (2008) conduct an extensive simulation study to compare the efficiency
of estimation of asset correlation through equity prices to that of estimation through default rates. Their
results suggest that asset correlation estimates based on equity returns are always more efficient than
correlations estimated with default rates, even if the model is misspecified.47 The KMV asset value model, as
set forth in Bohn & Crosbie (2003), may provide the best alternative in the assessment of asset correlations.
This method, however, may become very time-consuming when the number of issuers in the portfolio is
large. Consequently, plain equity returns will be used to estimate issuer asset correlation in this study.
47
This conclusion holds for estimation with direct equity returns and is even stronger for equity prices that are converted to asset
values by way of the KMV asset value model.
52
The main share of studies that have employed the equity correlation proxy utilize factor models. In such a
model, the linear (pairwise) correlations are based mostly on sector and industry indices. Factor models of this
kind were proposed by Gupton et al. (1997) as a solution to deal with many credit products in the
CreditMetrics model.48 Moreover, these models are supposed to filter out the noise in the asset or equity
returns and only assess the information that is actually useful (Elton & Gruber, 1973; Elton et al., 1978). Zeng
& Zhang (2001) provide an extensive assessment of these factor models. They compare their out-of-sample
forecasting accuracy with that of historical correlations and conclude that historical correlations perform
relatively well when enough data is available. A few factor models do however systematically outperform
historical correlations, especially when the available data is limited. In the setting of this study, enough data is
available and as a result, simple historical (equity) return correlations are used. In an actual trading portfolio,
the number of positions will be much larger and then a multiple factor model will provide a better solution.
The next step is to specify the estimation periods on which the equity correlation sets will be based. In the
model estimations in Part III, the equity return correlations between all underlying issuers in assessed
portfolios are required.49 Two estimation periods are interesting in the assessment of the effect of alternative
inputs and assumptions in the proposed incremental risk model. The first of the two periods obviously is the
credit crisis, which also (to a reasonable extent) represents the market environment at the estimation date of
the model (01/05/2009). Numerous studies find that correlations in financial markets increase during times of
economic turbulence (e.g. Lee & Kim, 1993; Forbes & Rigobon, 2002; Rigobon, 2003; Cappiello et al., 2006).
In addition, an underestimation of correlation risk in the subprime mortgage market has been one of the most
pronounced causes of the credit crisis, making it especially informative to estimate the effect of rising issuer
correlations in the proposed incremental risk model. The relevant issuer equity correlations are estimated with
equity return information from the end of April 2007 till the end of April 2009, representing the credit crisis.
This two-year period starts one quarter earlier than the credit crisis period in the estimation of the credit crisis
migration matrix. This decision is based on the fact that a sufficient number of equity return observations is
required in the estimation of the correlation estimates.
The second period of interest is the two-year period before the credit crisis, the end of April 2005 till the end
of April 2007. This period represents a relatively stable environment. The two chosen periods provide the
required information for the assessment of the effect of correlations in different market conditions in the
model. In fact, the average issuer equity correlation among the issuers in the portfolio in the credit crisis
period is 0.44, whereas the average of the issuer correlations in the stable period is only 0.23. This substantial
difference confirms that conditional correlations increase during times of economic crisis and provides the
opportunity for a clear assessment of the effects of rising issuer correlations on the migration and default risk
in a credit portfolio.50 The exact model estimation results with these two different sets of correlations will be
discussed in Part III section 3.2.4.
Both sets of correlations are estimated using of two years of historical equity returns data. Such an estimation
may seem straightforward as the underlying equity data can be easily obtained. Nevertheless, multiple issues
have to be dealt with. First of all, the number of equity return observations must be high enough to estimate a
positive definite correlation matrix, otherwise the required Cholesky decomposition matrix cannot be
computed.51 The second issue is that the correlation estimates need to be as reliable as possible.
48
49
50
51
Factor loadings (betas) are estimated for each issuer instead of all correlations between all issuers. The factor loadings can be easily
converted to the required correlation coefficients.
The construction of the portfolios is discussed in section 2.3. The positions and their underlying issuers that constitute the
portfolios are presented in appendix A.3.
Conditional correlation coefficients are correlation coefficients that are not corrected for the heteroskedasticity that is present in
distressed markets.
When the correlation matrix is not positive and/or definite, which is a likely possibility when the number of credit products a rather
large, then the spectral decomposition of the correlation matrix must be estimated instead of Cholesky decomposition. Random
variables can also be correlated using spectral decomposition in a way similar to the application of the Cholesky decomposition. The
53
These issues may seem easily resolved by taking a large number of equity returns observation for each issuer,
yet another issue arises here. Namely, what is the return frequency that should be applied? The year and
monthly frequency clearly provide too few observations in a two-year estimation period. Gupton et al. (1997)
argue that 190 return observations should be taken into account in the process. Moreover, they propose a
weekly return frequency. Then, if weekly correlations are considered, the assumption must be made that
weekly equity correlations reflect actual underlying issuer asset correlations. The weekly return frequency
provides enough observations in a 2 year horizon (approximately 100 observations). This is substantially less
than Gupton et al. (1997) argue that is required, but enlarging the estimation period may result in correlations
that do not reflect the current market conditions anymore. One should not be willing to allow this to happen,
since the correlation issues that have emerged in the credit crisis emphasis that capturing the current market
environment is of crucial importance in the assessment of (correlation) risk in a portfolio.
The selection of the proper frequency is subject to another problem. Estimation based on a yearly, monthly,
weekly or daily returns yield different correlations estimates, making the reliability of the estimates doubtful.
Theory implies that correlation based on different return frequencies should be equal (at least on average), as
(linear) risk factors should affect returns all the time and not only at the end of the month or end of the year.
Such a periodical aspect in a risk factor takes away the risk from the risk factor since it become predictable.
The actual reason behind the observed phenomenon probably lies in the unstable, noisy, time-varying, nonlinear and/or indirect nature of the relations between issuers.52
To select an underlying return frequency that may suffer the least from this somewhat irresolvable problem,
issuer correlation matrices are estimated for both the two-year periods, based on the following returns
frequencies: daily, weekly, two weeks, three weeks and monthly. Using these matrices, the average correlations
are calculated for both two-year periods. Subsequently, the average correlation matrix of each period is
compared to the matrices with the different underlying frequencies. For both periods, the computed average
correlation matrix is most similar to the correlation matrix based on the weekly frequency. One could interpret
this information as evidence that the weekly correlation matrix is the most representative correlation matrix of
those of the considered frequencies for both sample periods, and therefore it may be most reliable. This
criterion may not be particularly strong, yet a frequency must be selected, while an extensive assessment of
correlations at different frequencies is beyond the scope of this study. The selection of the weekly frequency is
to some extent confirmed by the literature as well, as the weekly frequency is often applied in relevant studies
(e.g. Gupton et al., 1997; Zeng & Zhang, 2001). Consequently, the issuer equity correlations that will be
employed in the model estimations in Part III are based on weekly equity returns.
In addition to the issuer asset correlations, the issuer autocorrelations must be estimated as well. To calibrate
the model to display observed issuer autocorrelation correctly, actual autocorrelations have to be obtained.
More specifically, corr( Rt ,i , Rt 3,i ) for i 1,2,..., n has to be estimated from historical equity data ( n is still the
number of positions in the portfolio).
Herein, the underlying return frequency of the equity autocorrelations should be as close as possible to the
length of one period in the proposed incremental risk model (three months). In the estimation process of
autocorrelations, equivalent arguments essentially apply as those that were set forth in the issuer equity/asset
52
disadvantage of the procedure is that the calculation of the spectral decomposition of a matrix is much more difficult than the
calculation of the Cholesky decomposition. Furthermore, the derived correction (Part I section 1.4.5, equation 1.45) may not be
completely valid anymore. Nevertheless, the correction becomes less important when the number of periods in the model is
increased. In fact, the impact of the correction on the correlations in the four-period model is already incredibly small for all
correlations that are considered in the model estimations in this study. The largest correction that is applied is an increase of 4% of
the relevant input correlation. Consequently, the use of spectral decomposition will provide a relatively sound alternative in the use
of the model when no positive definite correlation matrix can be estimated. In this study, however, no such attempt will be made as
all considered correlation matrices are positive definite.
Note that the use of factor models may provide a partial solution here, since it is believed that these models filter out the noise and
produce more stable correlation estimates. Nonetheless, the solution is only partial as even within a factor model first the return
frequency must be specified. Essentially, one cannot assume that varying this specification does not alter the resulting estimates.
54
correlation case. For autocorrelations, however, it may be more important to select a frequency that is close to
the one that is used in the simulation model. Observed autocorrelations may be weaker for longer horizons
and besides, autocorrelation coefficients for different frequencies are directly related as the shorter horizons
constitute the longer ones. Another difference is that no positive definite correlation matrix required, since
only one correlation coefficient is used separately for each issuer in the simulation model. Still, a sufficient
number of returns observations is required to ensure that reliable coefficients can be estimated.
Due to the fact that the quarterly return frequency yields too few observations, the monthly frequency is
selected. For the two periods of two year, this frequency still generates a too small number of observations.
Therefore, the two periods are joined together. Thus, only one autocorrelation coefficient per issuer is
estimated which is based on both periods. Theory may imply that autocorrelation coefficients change during
times of financial turmoil, but such an effect is much less evident than it is for issuer correlations. In that
sense, the length of the frequency and number of observations are of much greater importance. Consequently,
the estimation of autocorrelation coefficients is based on the monthly return frequency and the entire fouryear period. The average of the autocorrelation coefficients of the 70 issuers that constitute the portfolios is
only 0.04, with a standard deviation of 0.17 and a maximum and minimum of 0.33 and -0.33, respectively.
The last few details on the estimated equity correlations are that the equity returns are computed as
logarithmic returns, which is consistent with the way the issuer asset returns and issuer autocorrelation
coefficients are treated in the correlation structure of the proposed incremental risk model. Lastly, the
required equity data for all issuers in the portfolios were obtained from Thomson Datastream.
2.2.2 Asset Correlation based on Default Rates
The second approach that is considered is the estimation of asset correlations based on default rates. The
intuition behind this approach is very simple. If default implies that the asset value of the issuer has dropped
below the value of its debt, then when the probability of two issuers jointly defaulting and individually
defaulting is known, their asset correlation can be estimated. The link between the joint default probability of
two issuers and the implied issuer asset correlation can be mathematically approached.
Consider issuer i and issuer j with default probabilities pD ,i and pD, j , respectively, and a joint default
probability denoted as pD,ij , all with respect to the same time horizon. Furthermore, let xi and x j denote the
asset values of issuer i and issuer j and let Z D ,i and Z D, j be the default thresholds of issuer i and j that
specify the asset value at which issuer i and j default. Hence, the joint default probability can be written as:
pD,ij P( xi Z D,i , x j Z D , j ) .
(2.12)
Applying this notation, the linear default correlation coefficient can be written as (Lucas, 1995):
D ,ij
pD ,ij pD ,i pD , j
pD ,i (1 pD ,i ) pD , j (1 pD , j )
(2.13)
Herein, it is assumed that asset values follow a multivariate normal distribution. Hence, ( xi , x j ) is bivariate
normal. Let ij denote the issuer asset correlation between asset values xi and x j . Then when f (u, v) is the
standard normal density function, the joint default probability of issuer i and j can be defined as:
Z D ,i Z D , j
pD ,ij
f ij (u, v)dudv .
(2.14)
The application of the bivariate Gaussian copula ensures that this equation can be expressed as:
pD ,ij
1
2 1 ij
Z D ,i Z D , j
s 2 2 ij st t 2
exp
dsdt .
2(1 ij2 )
(2.15)
55
Consequently, a relatively direct link between the asset values of two issuers is established under the Gaussian
assumption. Note that this is not very different from the Z-value methodology that was applied in Part I
section 1.2.2 and the Gaussian copula that links the Z-values of two issuers. Only in this case the link is
established through the Z-value of default only. The above specification is not really something new in the
context of what has already been addressed in this study. Nevertheless, the joint default probability ( pD,ij ) is a
required input in the equation. As a consequence, the essence of this issuer asset correlation estimation
methodology is the estimation of the joint default probability ( pD,ij ).
The estimation of the joint default probability relies in the cohort default probability estimator. In this, the
horizon that is considered for the correlation estimates must be specified, since the total sample period is
divided into cohorts with the length equal to that particular horizon. Within each cohort the default rate of
issuers belonging to group i is consistently estimated as:
pD ,i
Di (t )
,
N i (t )
(2.16)
where Di (t ) is the number of defaulted issuers in group i during horizon t and Ni (t ) is defined as the
total number of issuers in group i during horizon t .53
Employing the expression of the group specific default rate, the joint default probability of issuers in group i
and group j is defined as:
pD ,ij
Di (t ) D j (t )
.
Ni (t ) N j (t )
(2.17)
In this equation, pD,ij is defined as the probability that an issuer in group i and another issuer in group j
jointly default during horizon t . When i j then pD,ij is the intra-group joint default probability and when
i j then pD,ij is the inter-group joint default probability.
Similar to the cohort approach for credit rating matrices, following De Servigny & Renault (2003), the issuerweighted average is taken over all cohorts and both groups to arrive at the joint default probability of issuers
in group i and group j :
T
pD ,ij
t 1
N i (t ) N j (t )
Di (t ) D j (t )
,
Ni (t ) N j (t ) Ni (t ) N j (t )
T
(2.18)
t 1
where T is the number of cohorts included in the estimation.

In the estimation, the issuer-weighted average is preferred over the regular average, which is applied in Frey &
McNeil (2003). This choice may not have a theoretical justification according to Akhavein et al. (2005), but it
does have statistical justification. Basically, the cohorts that contain the most observations are weighted the
heaviest, since statistical theory implies that those cohorts will provide a more accurate estimate than those
with a small number of observations. Notice that time-varying joint default probabilities cannot justify the use
of a regular average in favour of the issuer-weighted average, as the time-homogeneity assumption has to be
made either way to be able take any kind of average out of the single-cohort estimates.
Equation 2.18 ensures that the joint default probabilities between the relevant groups of issuers can be
estimated. Subsequently, these estimates are utilized in the bivariate Gaussian copula density function to
obtain implied asset correlation estimates.54
53
54
The definitions of Ni (t ) and Di (t ) that are applied here are equivalent to those used in the estimation of the credit migration
matrix according to the cohort method (section 2.1.2).
The density of the bivariate Gaussian copula has no analytical solution. Usually, it is estimated using maximum or partial likelihood
functions/algorithms, but in this study a more simple simulation approach is taken. A very large amount of simulations ensure that
the correlation coefficient can be calibrated to reflect the known probabilities of default per industry and their joint probability of
default. Herein, the estimates are all based on two million simulations.
56
To ensure that the required joint default probabilities can be estimated, first groups of issuers (group i and
j ) have to be established. The implied asset correlations will be estimated between those groups and not
between specific issuers. Herein, the most imperative drawback of this method arises. To estimate correlations
with default rates, default data is needed. This data is scarce and therefore these groups of issuers have to be
sufficiently large to ensure enough default data is present in each issuer group. When no default observations
are present in a group, the default correlation and implied asset correlation within the group and with the
other issuer groups is equal to zero, according to the estimator.
In the literature, the most commonly applied method is to base the group definitions on industries. Hence,
this approach will be taken in this study as well.55 Company-specific and sector-specific information is ignored
in this method as a result of the required estimation on an aggregated basis. This loss of detail will most likely
result in an underestimation of the default correlation or implied asset correlation between a substantial
number of issuers in the assessed portfolio. Dllmann et al. (2007), for example, find that the use of issuerdependent asset correlation leads to substantially higher portfolio risk than sector dependent asset
correlations. Furthermore, it is frequently observed that asset correlations implied by default rates are much
lower than those estimated using equity returns or KMV-model based asset correlations (Gordy & Heitfield,
2000). Some specific information may be saved by conditioning on industries and other characteristics, but the
extent to which issuers can be clustered is very limited, due to the shortage in default observations.
A second disadvantage in estimation asset correlation based on default rates, is that the estimation sample has
to be reasonably long to be able to estimate statistically meaningful correlations. This requirement is even
more troublesome than it is in the equity return correlation proxy approach. The one-year capital horizon of
the model implies that a one-year correlation horizon must be considered. Hence, the length of a cohort in the
estimation is one year. Consequently, conditioning on the market conditions of the last one or two years
would yield meaningless estimates, since the estimation would be based on only one or two one-year
cohorts.56 To obtain estimates that are based on sufficient default data, a sample period of ten years is applied
in this study. More specifically, the estimation will be based on the last ten years of the S&P US credit rating
database that is applied in the estimation of the credit migration matrices. Obviously, this implies that the
default definition that is applied there is also applied in this estimation.
Besides the issuer asset correlations, the correlation structure of the proposed incremental risk model also
requires asset autocorrelations. To address this subject, a deeper understanding of the joint default probability
estimator is required. Equation 2.13 displays that default correlation between two issuer groups can be
estimated, using the joint probability of default between the groups of issuers and the average default
probabilities within those groups. The original joint default probability estimator, as applied by Lucas (1995),
Nagpal & Bahar (2001) and Frey & McNeil (2003), is as follows:
pD ,ij
Di (t )[ D j (t ) 1]
.
Ni (t )[ N j (t ) 1]
(2.19)
The rationale behind the original estimator is that the denominator counts the total number of issuer pairs
between group i and j and the numerator counts the number of those pairs that defaulted simultaneously.
55
56
The (first layer) industry groups in the Bloomberg Industry Classification Standard (BISC) are used as industry definitions. The
Government and Funds groups are not taken into account in this assessment, since the number of issuers in these groups was much
too low to produce reliable correlation estimates (13 and 3 issuers, respectively, in the entire US spectrum of S&P-rated issuers).
Conditioning on the credit crisis period for instance, would be meaningless, since only two cohorts with a one-year horizon would
be considered, which makes the reliability of the resulting estimates extremely doubtful. In essence, the implied asset correlations
cannot be conditioned to a period that is in line with the current market conditions without running into severe data issues.
Estimation based on a rolling window like in Akhavein et al. (2005) is not an option as well. Doing so will yield a severe overlapping
observations error, while the estimation will only contain limited extra information. In addition, the defaults at the start and the end
of the sample will be given much less weight in the estimation than the defaults in between. Hence, such an estimation will
definitely result in biased estimates. In fact, one might even argue that the data scarcity problem makes the estimation of issuer asset
correlation implied by actual default rates an unsuited method to assess correlation risk in the incremental risk model.
57
Hence, the result is the probability of an issuer from group i and an issuer from group j both defaulting
during time horizon t . The estimator was modified by De Servigny & Renault (2003) into the one presented
as equation 2.17, to ensure no spurious negative joint default probability could result from the estimator.
To return to the asset autocorrelation subject, essentially, there is no reason to assume that the rationale
behind this estimator does not hold for default correlation for the same issuer group in consecutive periods as
well. The resulting concept of default autocorrelation is theoretically easily justified as recessions or pressures
from the general economy or in industries, sectors or other groups often last longer than a few months. In
other words, if the default probability of a specific issuer or issuer group is high in a specific period, then it is
not unlikely that that default probability remains high the next period, as some default events are secondary
reactions to defaults of other issuers rather than being directly related to the original economic shock.
The following estimator can be employed in the estimation of the required joint or consecutive default
probability in consecutive periods within group i :
T
pD ,i ( t 1) i ( t )
t 2
N i (t 1) N i (t )
Di (t ) Di (t 1)
.
N i (t ) N i (t 1)
N
(
t
1)
N
(
t
)
i
i
(2.20)
t 2
In this expression, the length one cohort is obviously equal to the required autocorrelation frequency. In this
study, that required autocorrelation frequency is equal to the length of one single-period in the simulation
model (three months). Subsequently, the issuer asset autocorrelation coefficients, that are required in the
correlation structure of the proposed incremental risk model, can be estimated, using the bivariate Gaussian
copula density function. Again, herein the last ten years of the S&P credit rating database are used as well as
the industry group definitions.
Table V displays the estimated implied asset correlations between industries (the off-diagonal elements in the
correlation matrix) and within industries (the diagonal of the matrix). In the row below the correlation matrix,
the implied asset autocorrelation are shown per industry. All correlation estimates are based on the Gaussian
correlation assumption. The corresponding default correlations estimates are given in appendix A.2.
The estimates of the implied asset correlations in table V are even lower than expected. De Servigny &
Renault (2003), for example, present much higher estimates. Nonetheless, their estimates are based mainly on
issuers with speculative grades, resulting in a strong increase in the implied correlation coefficients. In
addition, the implied asset correlation estimates are much lower than the average estimated equity correlations
as well. This is often the case with estimates based on historical default rates, as stated in Gordy & Heitfield
(2000) and Dllmann et al. (2007, 2008). The effect can at least partially be attributed to the necessary
clustering of the issuers, resulting in non-homogenous (large) groups of issuers on which the correlations are
based. The result of these non-homogenous groups is an erosion of the correlation characteristics of the
individual issuers. Consequently, useful issuer-specific correlation information is ignored due to the
aggregation effect in the large industry groups.
TABLE V - Implied Issuer Asset Correlations Based on Observed Default Rates
1. Basic Materials
2. Communications
3. Consumer C.
4. Consumer NC.
5. Diversified
6. Energy
7. Financial
8. Industrial
58

1.
2.
3.
4.
5.
0.094
0.096
0.064
0.060
0.023
0.096
0.152
0.073
0.066
-0.068
0.064
0.073
0.056
0.063
-0.001
0.060
0.066
0.063
0.097
0.026
0.023
-0.068 -0.001
0.026
0.161
0.033
0.091
0.048
0.059
-0.009
0.023
0.074
0.046
0.057
-0.075
0.078
0.115
0.061
0.066
-0.034
6.
0.033
0.091
0.048
0.059
-0.009
0.117
0.065
0.067
7.
0.023
0.074
0.046
0.057
-0.075
0.065
0.109
0.044
8.
0.078
0.115
0.061
0.066
-0.034
0.067
0.044
0.098
9.
0.082
0.075
0.083
0.106
0.066
0.091
0.041
0.091
10.
-0.017
0.012
-0.022
-0.009
-0.058
0.006
-0.086
0.028
9. Technology
10. Utilities
Autocorrelation
0.082
-0.017
0.056
0.075
0.012
0.105
0.083
-0.022
0.023
0.106
-0.009
0.037
0.066
-0.058
-0.124
0.091
0.006
0.073
0.041
-0.086
0.061
0.091
0.028
0.047
0.163
-0.071
0.091
-0.071
0.120
0.023
The upper matrix displays the implied asset correlation between industries and within industries (the diagonal). The row under the matrix shows the
implied asset autocorrelations. Consumer C. = Consumer Cyclical and Consumer NC. = Consumer Non-Cyclical. Both the underlying one-year
industry default probabilities and one-year joint default probabilities are computed, using an issuer-weighted average of the relevant 10 one-year
(joint) default probabilities (one for each year in the estimation period). Both the underlying three-month industry default probabilities and threemonth joint default probabilities are computed, using an issuer-weighted average of the relevant 40 and 39 three-month (joint) default probabilities
(one for each quarter in the estimation period), respectively.
One might be able to enforce an increase in the implied asset correlations in table V when more groups are
considered, making the groups more homogenous. The largest BICS industry groups contain enough default
observations to be split up one or two times more or another industry classification standard could be used
that contains more first layer industries. As much as 20-25 groups may be employed, yet correlations will
remain relatively low, as very significant amount of aggregation is always necessary. Moreover, a larger number
of groups may increase the severity of the sample period length issue. In essence, groups containing fewer
issuers will require a longer sample period (more default data) to obtain statistically meaningful estimates.
In Part III section 3.1.2, the economic implications of the implied asset correlation estimates are discussed in
the model estimation context. Nonetheless, the (too) low implied issuer asset correlation estimates already
indicate that it is highly likely that these implied asset correlations will result in an underestimation of the
correlation risk in a portfolio of credit products.
2.3
CORPORATE BOND PORTFOLIOS

The last inputs that have to be calibrated are the portfolios that will be used in the estimation of the proposed
incremental risk model. These portfolios are not part of the actual model, nor can they be defined as inputs
that need to be estimated. Yet, they do serve an important objective in this study.
The portfolios serve two purposes. The first purpose is that they ensure that the incremental risk model, as
proposed in Part I, can be estimated and that the effects of the assumptions and inputs of the model can be
assessed. The second purpose of the portfolios is that they are themselves an essential source of input
variation in the model. Hence, multiple portfolios are created. In this section, the characteristics of these
portfolios are evaluated. As mentioned, only corporate bond portfolios will be employed in this study. First,
the construction of each portfolio will be discussed. Subsequently, the required liquidity horizon assumptions
of the individual positions in each portfolio will be addressed.
2.3.1 Portfolio Construction

In order to address the effect of the assumptions or inputs of the model in a meaningful way, it is critical that
realistic trading portfolios are constructed. Four criteria are accounted for in this context: (1) diversification in
the portfolio, (2) the percentage of the portfolio invested in each credit class, (3) the percentage long and short
in the portfolio and lastly, (4) the duration of the portfolio and per group of bonds in a specific credit class.
Following Dunn (2008), three portfolios are formed: a diversified long-only portfolio, a diversified portfolio
with both long and short positions and a similar long-short portfolio with a few concentrated positions.
The natural starting point is the construction of an average diversified long-only corporate bond portfolio.
The justification for such a portfolio is that many passive investors buy relatively low risk index funds, which
are mostly comprised of only long positions. Nevertheless, as Dunn (2008) points out, this is an unrealistic
assumption for real trading portfolios of large institutions, since they hold a substantial amount of short
positions. Hence, a diversified bond portfolio with both long and short positions must be created as well.
In the construction of both the long-only and the long-short portfolio, the long-only portfolio is closely
related to the long-short portfolio, since the long-short portfolio structured such that it holds the same long
positions as the long-only portfolio. The diversification objective in the portfolios is achieved by selecting one
corporate bond from one single issuer from each of 66 second layer industry groups in the Bloomberg
59
industry classification standard (BISC). As mentioned before, only US issuers are considered. Due to the large
number of issuers of a few in these industry groups and the fact that only a limited number of these groups
contain AAA-rated issuers and AA-rated issuers, two issuers are taken from the following four second layer
BISC groups: Banks, Insurance, Telecommunications and Gas. Consequently, the total number of issuers and
corresponding corporate bonds that are considered is 70.
To simplify the exercise, the 70 utilized bonds are not completely identical to existing bonds of the respective
70 issuers, as the coupon dates of all bonds set to the 1st of May each year and are set to be paid annually
instead of semi-annually. The bonds do, however, closely resemble the existing bonds of the relevant issuers
in terms of maturity and coupon size.57 Herein, the maturities all range between 1 and 15 years with an average
of 7.26. Hence, both the long-only and long-short portfolios can be classified as intermediate maturity bond
portfolios relative to the US corporate bond universe. Furthermore, the coupon percentages of all bonds are
between 0% and 15%, with an average of 6.71%.
In the composition of the long-short portfolio, Dunn (2008) argues that 60% long and 40% short is a
reasonable reflection of trading positions at major institutions. Following this claim, the long-only portfolio is
formed with 42 of the 70 bonds and the long-short portfolio contains the remaining 28 bonds as short
positions. Dunn (2008) also states that a reasonable assessment of the portfolio composition of large trading
institutions is 70% investment grade and 30% speculative grade, where the position size declines for lower
credit ratings. This claim is implemented in the construction of the portfolios as well. More detailed
information on the rating characteristics of the long and long-short is presented in table VI. The long-only
portfolio contains only the long positions that are displayed in panel A and the long-short portfolio comprises
both the long positions in panel A and the short positions in panel B. As shown in the table, the total value of
the long portfolio is $6.6 million. The relative exposure to the specific rating classes is displayed in the fifth
column (Rating Class %) in both the panels in the table. The long and short positions are chosen such that the
relative exposures to each rating class are roughly equivalent in the short and the long components of the
long-short portfolio. Moreover, the composition adheres to the 70% investment grade vs. 30% speculative
grade structure in both the long-only and the long-short portfolio.
TABLE VI - Portfolio Details of the Long and Long-Short Corporate Bond Portfolios
AAA
AA
A
BBB
BB
B
CCC/C
Total
AAA
AA
A
57
A. Long positions
Number of
Positions
4
7
7
7
7
6
4
42
B. Short positions
Number of
Positions
3
4
5
Value per
Position
$225,000
$200,000
$200,000
$150,000
$150,000
$100,000
$50,000
Rating Class
Exposure
$900,000
$1,400,000
$1,400,000
$1,050,000
$1,050,000
$600,000
$200,000
$6,600,000
Rating Class
%
13.64%
21.21%
21.21%
15.91%
15.91%
9.09%
3.03%
100.00%
Average
Duration
6.20
5.81
5.74
5.86
5.64
5.14
4.15
5.72
Average
Maturity
8.00
7.43
7.43
7.29
7.29
7.33
5.75
Average
Coupon
4.75%
5.43%
5.29%
8.00%
7.00%
8.33%
9.75%
Value per
Position
-$225,000
-$200,000
-$200,000
Rating Class
Exposure
-$675,000
-$800,000
-$1,000,000
Rating Class
%
15.43%
18.29%
22.86%
Average
Duration
6.11
5.90
5.52
Average
Maturity
7.33
7.25
6.80
Average
Coupon
4.67%
6.00%
6.20%
For a few issuers no existing bonds could be found in Thomson Datastream. In those few cases, bonds where completely made up,
yet the maturity and coupon size were set to roughly correspond to the average within the rating class. The specific issuers and
bonds to which this applies can be found in appendix A.3.
60
BBB
BB
B
CCC/C
Total
5
4
4
3
28
-$150,000
-$150,000
-$100,000
-$50,000
-$750,000
-$600,000
-$400,000
-$150,000
-$4,375,000
17.14%
13.71%
9.14%
3.43%
100.00%
5.95
5.44
5.03
4.20
5.65
7.80
7.75
6.50
7.33
5.40%
6.75%
8.50%
8.33%
The duration of the total denotes the duration of all short or all long positions. All issuer ratings underlying the table are from 01/05/2009, as that
is the model estimation date. The rating class exposure denotes the exposure to the specific rating class and the rating class % denotes the relative
long or short exposure to the specific rating class. Duration and maturity are both presented in years.
Another important characteristic of a bond portfolio is the duration, which signals the sensitivity to interest
rate/yield changes. The duration measure might especially be an effective tool in the assessment of migration
risk in bond portfolios as its use assumes parallel movement of the yield curve. Credit migrations of issuers
mostly generate such movement as yield curves of different rating classes often have similar shapes. Due to
these features of the duration concept, it is important to account for it in the formation of the corporate bond
portfolios. The duration of the long-only portfolio is 5.72 as shown in table VI. As a comparison to that
number, the average duration of the Barclays US Corporate Intermediate Bond Index at 01/05/2009 was 4.39
and that of the Barclays US Corporate Long Bond Index was 11.25 at that same date. Hence, the long-only
portfolio is slightly more sensitive to yield changes than the bonds underlying the Barclays US Corporate
Intermediate Bond Index. Therefore, in the duration context, the portfolio can also be defined as a relatively
intermediate portfolio.58 This intermediate nature of the portfolio adds to the usefulness of the model output
that will be generated by the portfolio, since it will reflect the required average nature of the portfolio.
Consequently, the estimation results reflect the effects that would occur in an average setting.
The total absolute exposure of the long-short portfolio is $10.975 million, since it comprises both the long
positions in panel A in table VI and the short positions in panel B. The net exposure is only $2.225 million.
The long positions make up 60.14% of the portfolio and the remaining 39.86% is made up of short positions.
In this portfolio, the bond durations are even more important, as the portfolio can be seen as a bundle of
assets and liabilities. Duration is used very frequently in the management of risk in an asset-liability context. In
the construction of the portfolio, the duration per rating class was the driving factor. As displayed in the table,
the durations per rating class and in total are almost equivalent when the long and short positions are
compared. It is not unreasonable to assume that large institutions may follow a similar rule, since it implies
that the yield or interest rate sensitivity is equal for both the long and short positions. Partially as a result of
that, the constructed long-short portfolio may be a reasonable approximation of an average real trading
portfolio in terms of durations, maturity, coupon, long-short exposures and relative exposure per rating class.
Appendix A.3 provides the details of all individual bonds in the portfolios (maturity, coupon and duration).
With the complete specification of the long only and the long-short portfolio in place, it is time to move on to
the long-short portfolio with concentrated positions. The evaluation of such a portfolio in the proposed
model displays to what extent the credit risk in a portfolio increases when some large positions are introduced
into the portfolio. In practice, many financial institutions have some major positions at some point in time and
therefore, it is extremely relevant to estimate what the effects of these positions are on the migration and
default risk of the complete bond portfolio.
To construct this portfolio the long-short portfolio is copied, yet two positions are enlarged to serve as
concentrated positions. The relatively low risk A-rated Goldman Sachs Group Inc (long) position is increased
from $200,000 to $800,000, while the other A-rated long positions are reduced from $200,000 to $100,000. In
relative terms, this implies that the Goldman Sachs position is increased from 3.03% to 12.12% of the total
value of the long positions in the portfolio. The total value of the long positions has not changed due to the
decreased value of the other A-rated positions. The second position that is enlarged is the relatively risky B58
When the two Barclays indices are combined, an 80.61% weight for the Barclays US Corporate Intermediate Bond Index and a
19.39% weight for the Barclays US Corporate Long Bond Index will yield a duration equal to that of the long only portfolio.
Therefore, the long only portfolio shows a much closer resemblance to an intermediate (duration or maturity) bond portfolio then
is does to a long (duration or maturity) bond portfolio.
61
rated Alliance One International Inc position. This (long) exposure is increased from $100,000 to $500,000 or
in relative terms from 1.52% to 7.58% of the total value of the long positions in the portfolio, while the other
B-rated long positions have been reduced from $100,000 to $20,000. Again, the decline in the value of the
other B-rated long positions ensures that the total value of the long positions in the portfolio remains equal.
Obviously, the net exposure does not change as well. Furthermore, the duration of the long positions changes
only slightly from 5.72 to 5.53, while the duration of the short positions obviously does not change at all.
2.3.2 Liquidity Horizons
As pointed out in the guidelines of the incremental risk model, the liquidity horizon of a credit product
represents the amount of time it may take to sell or hedge all material risks covered by the incremental risk
model in stressed market conditions. The liquidity horizon concept is a relatively new feature in the Basel II
Framework and in the empirical literature as well. Of course, numerous studies have addressed the liquidity
subject in the credit risk context.59 However, few if any have addressed liquidity in the form set forth by the
model guidelines. Although the subject is extremely relevant as well as interesting in the current market
environment, proposing a model of that form is beyond the scope of this study.
Even so, the liquidity horizons of all bonds are required inputs in the estimation of the proposed incremental
risk model. Consequently, reasonable assumptions have to be made with respect to the liquidity horizons that
will be employed in the model estimations. Herein, only one simple rule is followed: the liquidity horizon
should be longer for bonds with a lower underlying issuer credit quality. This rule is obviously based on the
well known flight for quality during times of severe market turmoil and is also cited in the incremental risk
model guidelines. Employing this simple rule, the following assumptions with respect to the liquidity horizons
of the individual positions in the portfolio are proposed:
AAA, AA
qi 3 ,
A, BBB, BB
qi 6 ,
qi 9 ,
CCC/C
qi 12 ,
where qi is the length of the liquidity horizon of position i in months.

This set of liquidity horizon assumptions is applied in all three portfolios. The only exemption is that in the
long-short portfolio with concentrated positions, the liquidity horizons of the two concentrated positions are
increased by three months relative to the rule expressed above. In essence, the length of the liquidity horizon
is likely to be longer for concentrated positions, simply due to the fact that it takes much more time to sell or
hedge the risks of a large position or concentration in a stressed market environment. Capturing effects of this
nature is essentially one of the main motives behind the introduction of the liquidity horizon concept. In fact,
the incremental risk model guidelines explicitly state that the liquidity horizon is expected to be higher for
concentrated positions.
The liquidity horizon is the last assumption or input that had to be specified to enable the estimation of the
proposed incremental risk model. In addition, the effect of this particular assumption on the model output is
an important point of interest as well. Such an assessment can be produced by varying the liquidity horizon
assumption (i.e. increasing or decreasing the liquidity horizons). Obviously, the relevance in the estimation of
these effects is easy to identify, since it creates the opportunity to quantify the effect of an underestimation of
the liquidity horizon of certain credit products. More essential, however, is that an assessment can be made on
the relative importance of the liquidity horizon in the model. For example, when changing the liquidity
horizons only results in a marginal change in the 99.9% one-year value-at-risk measure, then the relative
59
Examples of studies that address the subject of liquidity in the credit risk context are Duffie & Ziegler (2003), Houweling et al.
(2005), Ericsson & Renault (2006), Chen et al. (2007), Tang & Yan (2007) and Nashikkar et al. (2009).
62
importance of the liquidity horizon in the model may become somewhat submerged in practice. Such
information sheds light on the whether or not the objective of the Basel Committee to make liquidity a key
factor, underlying the Incremental Risk Capital Charge, is likely to be achieved in reality. This subject will be
treated in Part III section 3.1.3 and in the conclusions.
PART III
MODEL ASSESSMENT
In Part I, the technical and theoretical structure

of the proposed incremental risk model have been
defined. In essence, the entire model has been
described here. In Part II, the required inputs of
the model were estimated and calibrated with the
use of various alternative estimation
methodologies. Moreover, three corporate bond
portfolios were constructed, to be able to perform
the necessary model estimations. Hence, Part III
will contain an assessment of the proposed model
and its inputs and assumptions in the form of
model estimations and interpretations. In section
3.1, the proposed model will be estimated,
applying a variety of combinations of
assumptions and inputs. The model is estimated
70 times. In the application of the information
produced by the model estimations, section 3.2
presents a thorough interpretation of these results
in a model specific but also in general context
(where relevant or possible). First, the inputs
and assumptions that are most imperative to the
model are identified. Subsequently, all major
components of the model are addressed once
again and possible improvements and limitations
are discussed in detail. Herein, the central topics
are: the scope of the exercise, the stand-alone
risk specification, the issuer correlations and
autocorrelations, the constant level of risk
assumption
and
additional
valuation
assumptions. Part III ends with the discussion
of the more general topic concerning the position
of the Incremental Risk Capital Charge within
the Basel II Market Risk Framework.
Basically, the new definition of market risk
capital is evaluated here.
63
3.1
MODEL ESTIMATION
As stated before, various assumptions were utilized in the construction of the proposed incremental risk
model. In addition, different methodologies have been applied in the estimation of the inputs that are required
in that model. Hence, numerous specification options have been generated for the estimation of the model.
This section will address a large variety of these model estimation specifications. The four main topics are: (1)
the stand-alone risk specification, (2) correlations, (3) the liquidity horizons and (4) concentrations. The
distributional or copula assumption will play a part in each series of model estimations in each section, since
all models will be estimated under the Gaussian assumption as well as two different t-Student assumptions.
First, a general model specification is required to form a base model from which the inputs can be changed.
The assumed estimation date of this particular model is 01/05/2009, as that is the date after the day from
which the last migration data and equity data is obtained. Hence, in each model estimation, the forward bond
valuation is based on the zero credit yield curves of 01/05/2009 as well. Further details on these credit curves
are provided in appendix A.4. In addition, the general model specification utilizes the unconditional duration
migration matrix, the credit crisis equity correlation (since this correlation set represent the current market
environment at the estimation date), the equity autocorrelations and the standard liquidity horizons, according
to the assumptions presented in Part II section 2.3.2.
In the model estimations, the required output is the one-year 99.9% value-at-risk estimate. However, to gain
more insight in the actual workings of the model and to create a greater sense of the default and migration risk
measurement produced by it, the 99% and 95% one-year VaRs are estimated as well. In addition, multiple
illustrative probability distribution and cumulative probability distribution graphs, with respect to the total
one-year portfolio returns, are displayed where relevant. Furthermore, the upper and lower bounds according
to the 95% confidence interval around each VaR-estimate are also computed, as described in Part I section
1.3.4. These two bounds for each VaR-estimate specify the range in which that VaR-estimate may lie with a
confidence of 95% and therefore ensures that value-at-risk estimates generated with the model with equal VaR
confidence levels, but subject to different inputs, can be statistically compared. Moreover, the relative width
of this range contains information about the degree of certainty of the relevant VaR-estimate. The main factor
driving the certainty of the VaR-estimates obviously is the number of simulations. This number is set to
200,000 for each specific model, ensuring a great level of stability in all three resulting VaR-estimates.
One last general specification is still required. As stated, the model will also be estimated under the t-Student
copula assumption. Herein, the tail dependence has to be specified in the form of the degrees of freedom of
the applied the Students t-copula, which naturally relates to the assumed issuer asset return distribution.
Multiple studies address the issue of the estimation of the proper degrees of freedom for the Students tdistribution in describing asset returns. Nevertheless, these studies mainly address the daily return frequency.
In this context, Cont (2001) discusses the empirical properties of daily asset returns and states, as a stylized
fact, that the degrees of freedom of asset returns is between the value of two and the value of five in nearly all
datasets studied in the literature. As a recent example, LeBaron (2009) finds that the Students t-distribution
with three degrees of freedom best characterizes daily return data. In the proposed incremental risk model,
however, the return horizons are quarterly and yearly. Longer horizon returns relative to daily returns may
display less excess kurtosis (fat tails), as extreme daily asset value movements may be absorbed by average or
normal daily returns and extreme returns of the opposite sign in the generation of the quarterly or annual
64
return.60 Hence, to generate a clear picture on the effects of the copula assumption, two t-Student copula
specifications are applied: a relatively high risk high tail dependence specification, where the degrees of
freedom is equal to the value of 5 ( 5 ), and an intermediate tail dependence specification, where the
degrees of freedom is equal to the value of 15 ( 15 ).61 These two t-Student copula specifications, as well as
the Gaussian copula, will be employed for each model estimation, allowing for an examination of the effect of
tail dependence on the model implied risk (the copula assumption effect).
3.1.1 Stand-Alone Risk
The first subject that is addressed, in the evaluation of the model specifications, is the stand-alone risk
specification. In other words, the four different credit migration matrices that were estimated in Part II section
2.1 will be employed to generate the required risk measures. The estimations create the opportunity for a
comparison of the required value-at-risk measures, generated with the use of different estimation
methodologies or estimation samples in the estimation of the applied credit migration matrix. The four
different credit migration matrices will be used in the model estimations, while the general specification will be
applied with respect to the remaining inputs. The models are estimated for both the long-only portfolio (L)
and the long-short portfolio (LS), and under each of the three copula assumptions.
Table VII displays all estimation results. Each panel (A, B, C and D) contains the results for a different credit
migration matrix. All single panels in their turn hold the results for the two portfolios (L and LS) and within
each portfolio the results for the three copula assumptions are given (N, t-5 and t-15). For each model
estimation, the 99.9% VaR-estimate is displayed in millions (column three) and in terms of a percentage of the
initial portfolio value (column four), as are the 95% confidence bounds of the 99.9% VaR-estimate (column
five and six). Furthermore, the 99% VaR-estimate and confidence bounds (column seven to ten) for each
model estimation and the 95% VaR-estimate and confidence bounds (column eleven to thirteen) are shown as
a percentage of the initial portfolio value as well.
The first points of attention are the VaR-estimates resulting from the duration migration matrix (panel A), the
cohort migration matrix (panel B) and the Aalen-Johansen estimator (AJE) migration matrix (panel C)
specifications. In the comparison of the 99.9% VaR-estimates per portfolio and copula assumption, a
consistent pattern is found. Although the differences are not always significant, the use of the cohort matrix
consistently generates a slightly larger 99.9% VaR-estimate then the duration matrix and AJE matrix per
copula assumption.62 The difference is less than 2% on average. The duration and AJE matrix display no
constant pattern in their outputs relative to each other. Both migration matrices generate roughly equivalent
99.9% VaR-estimates. When the 99% VaR-estimates are considered for the same specifications, all three credit
migration estimation methodologies produce approximately equal VaR-estimates per portfolio and copula
assumption. The 95% VaR-estimates show again another pattern, as the use of the duration and AJE
60
61
62
Conversely, following Fellers convolution theorem (Feller, 1971), the tail dependence of quarterly and yearly asset return should be
equal to that of the daily frequency, as those returns are the sum of a large number of daily returns. This implies that the degrees of
freedom for the applied t-Student copula should be between the value of two and five as well. Nonetheless, since daily returns are
not expected to be completely independent (which is not in line with the application of Fellers convolution theorem), and to create
a more detailed picture of the effects of the copula, two different t-Student specifications, or tail risk specifications, are applied.
The proper degrees of freedom to be employed in the Students t-distribution can be estimated with the use of historical data by
applying the Hill-estimator (Hill, 1975) or modified Hill-estimator (Huisman et al., 2001), or even better, the proper degrees of
freedom to applied the t-Student copula can be directly estimated as well. Although estimations as such would be very appealing in
the context of the model, they are beyond the scope of this study. Consequently, a high and a medium t-Students tail dependence
specification are employed, such that the effects of different degrees of freedom assumptions can be approached.
Significance is based on the computed 95% confidence bands of the compared VaR-estimates. Consequently, the applied
significance level is 5%. Note that this statistical inference applies to the simulation only. In fact, the simulations assume that the
input parameters display the true values. This assumption is obviously flawed, yet the statistical conclusions based on the 95%
confidence bands do allow for the identification of meaningful differences in the VaR-estimates induced by different sets of inputs
and assumptions.
65
migration matrices consistently generates slightly higher estimates than the cohort migration matrix. In
addition, this difference is significant in almost every comparison and is as small as 0.3% on average.
The duration migration matrix and the AJE migration matrix obviously generate approximately equal risk
measures due to their large similarities. Furthermore, the most apparent reason of the slightly higher 99.9%
VaR-estimates for the cohort matrix specification may be found in the fact that the cohort matrix contains
higher default probabilities for the lower graded issuers, except for the CCC/C category. The 99.9% worst
loss is not likely to be affected to a great extent by the higher CCC/C default probability in the duration and
AJE migration matrices, since this scenario is so far left in the tail of the portfolio return distributions that the
maximum of defaults in the CCC/C category is likely to be reached anyway. As a consequence, the slightly
higher default probability for the A, BBB, BB and B rating classes in the cohort migration matrix almost
certainly produced the larger 99.9% VaR-estimates.
A similar way of thinking applies when the higher 95% VaR-estimates generated with the duration and AJE
migration matrices, relative to those resulting from the cohort matrix, are considered. These loss scenarios are
far less extreme and therefore the larger CCC/C default probabilities do affect these risk estimates, since the
number of CCC/C defaults in the relevant simulation scenarios will not nearly reach its maximum.
Consequently, the 95% VaR-estimates are higher for the duration and AJE migration matrix specifications.
66
TABLE VII - Incremental Risk Model Estimates: Credit Migration Matrices

A. Duration migration matrix
Portfolio
L
LS
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
N
t-5
t-15
$1.018
$2.013
$1.475
$0.548
$0.929
$0.713
15.42%
30.50%
22.35%
24.65%
41.74%
32.05%
14.96%
29.22%
21.62%
24.01%
40.36%
31.18%
16.04%
31.88%
23.36%
25.75%
43.13%
33.06%
7.00%
12.46%
9.43%
12.63%
17.28%
14.75%
6.86%
12.20%
9.22%
12.41%
16.88%
14.41%
7.14%
12.81%
9.66%
12.84%
17.67%
15.01%
1.60%
2.48%
2.04%
5.12%
5.07%
5.26%
1.54%
2.39%
1.98%
5.05%
4.96%
5.16%
1.66%
2.57%
2.11%
5.21%
5.19%
5.36%
B. Cohort migration matrix

Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$1.062
$2.204
$1.541
16.09%
33.40%
23.34%
15.61%
32.29%
22.29%
16.64%
35.39%
24.01%
7.05%
12.51%
9.34%
6.86%
12.13%
9.10%
7.22%
12.85%
9.53%
1.40%
2.02%
1.80%
1.33%
1.93%
1.72%
1.46%
2.12%
1.88%
LS
N
t-5
t-15
$0.601
$0.963
$0.768
27.03%
43.29%
34.56%
26.28%
41.52%
33.55%
28.14%
45.47%
35.78%
13.08%
17.72%
14.99%
12.79%
17.27%
14.67%
13.35%
18.14%
15.30%
4.95%
4.72%
4.93%
4.86%
4.61%
4.84%
5.04%
4.83%
5.03%
Portfolio
C. Aalen-Johansen estimator migration matrix

L
N
t-5
t-15
99.9%
VaR*
$1.028
$1.940
$1.476
LS
N
t-5
t-15
$0.558
$0.858
$0.755
Portfolio
Copula
99.9%
VaR %
15.57%
29.39%
22.37%
Upper
Bound
15.05%
28.02%
21.52%
Lower
Bound
16.25%
30.92%
22.98%
99%
VaR %
7.05%
11.62%
9.07%
Upper
Bound
6.88%
11.29%
8.86%
Lower
Bound
7.22%
11.99%
9.31%
95%
VaR %
1.59%
2.27%
2.00%
Upper
Bound
1.52%
2.19%
1.95%
Lower
Bound
1.64%
2.35%
2.08%
25.09%
38.54%
33.94%
24.46%
37.12%
32.66%
26.06%
39.95%
34.84%
12.60%
16.52%
14.59%
12.38%
16.19%
14.26%
12.83%
17.00%
14.88%
5.12%
4.92%
5.19%
5.03%
4.80%
5.09%
5.19%
5.05%
5.27%
Upper
Bound
11.37%
18.19%
14.17%
17.48%
22.93%
19.81%
Lower
Bound
11.81%
19.03%
14.66%
17.98%
23.90%
20.51%
95%
VaR %
4.93%
6.40%
5.79%
8.40%
9.04%
8.90%
Upper
Bound
4.84%
6.26%
5.70%
8.31%
8.90%
8.78%
Lower
Bound
5.00%
6.52%
5.89%
8.51%
9.18%
9.00%
D. Duration migration matrix conditional to the credit crisis period

Portfolio
L
LS
Copula
N
t-5
t-15
N
t-5
t-15
99.9%
VaR*
$1.411
$2.862
$2.036
$0.733
$1.199
$0.928
99.9%
VaR %
21.38%
43.36%
30.85%
32.92%
53.89%
41.69%
Upper
Bound
20.90%
41.63%
30.07%
32.08%
52.01%
40.25%
Lower
Bound
22.22%
45.06%
31.48%
33.77%
55.74%
43.01%
99%
VaR %
11.59%
18.66%
14.41%
17.73%
23.37%
20.11%
* The 99.9% VaR values are reported in millions. All estimates are based on the credit crisis period equity correlations and equity autocorrelations. The
applied liquidity horizons are the standard liquidity horizons. Portfolio L is the long only portfolio and Portfolio LS is the long short portfolio. Copula
N is the Normal or Gaussian copula and copulas t-5 and t-15 are the t-Student copulas with underlying Student t-distributions with 5 and 15 degrees of
freedom, respectively. The estimates reported in percentages are relative to the initial portfolio exposure, which is $6.6 million for the long-only
portfolio and $2.225 million for the long-short portfolio. The upper bound and lower bound represent the 95% confidence interval around the VaR %
estimate presented left of them. All estimates are based on 200,000 simulations.
The fourth utilized migration matrix is the duration matrix conditional to the credit crisis (panel D in table
VII). This migration matrix contains much more downgrade potential than the three unconditional migration
matrices. In the comparison of all VaR-estimates generated by the conditional migration matrix relative to the
results of the unconditional migration matrices, the differences are extremely clear, as the conditional credit
crisis migration matrix consistently generates much higher risk measures than its unconditional counterparts.
The 95% VaR is 4% higher on average for the conditional migration matrix, while the 99% VaR is more than
5% higher on average. In the case of the 99.9 % VaR, the difference dependents considerably more on the
copula assumption than it does for the other two VaR-measures. The Gaussian copula returns a 6% difference
on average, the Student t-copula with 5 degrees of freedom results in a 13% difference on average, and the
67
Student t-copula with 15 degrees of freedom accounts for an average difference of 9%. In this, the differences
are significant and more importantly, they are substantial. Notice that the relative increase is much lower in the
long-short portfolio than it is in the long-only portfolio. The simply explanation for this outcome is that the
conditional migration matrix also ensures that the short positions have a more downgrade and default
potential, effectively generating a higher likelihood of profits on that side of the portfolio.
The main conclusion that results from all
model estimation results in table VII is that
the most essential factor in the stand-alone
risk specification is the conditionality of the
migration matrix. Figure IV displays part of
the
portfolio
return
probability
distributions for all four migration matrix
specifications for the long-short portfolio
under the Gaussian copula assumption. It
is clearly visible that the likelihood of
severely low portfolio returns is
substantially larger when the conditional
credit crisis migration matrix is applied.
The use of the three unconditional
migration matrices does not result in
observably different portfolio return
distributions according to the figure.
Nevertheless, a much clearer view is
FIGURE IV - Portfolio Return Probability Distribution
The remaining utilized model specifications are the Gaussian copula assumption,
the credit crisis equity correlation, the equity autocorrelations and the standard
liquidity horizons. The estimated distributions concern the results for the longshort portfolio. The portfolio return probability is equal to the frequency divided
by 200,000 (the number of simulations).
FIGURE V - Cumulative Portfolio Return Probability Distribution: Credit Migration Matrix Comparison
The remaining utilized model specifications are the Gaussian copula assumption, the credit crisis equity correlation, the equity autocorrelations and the
standard liquidity horizons. The estimated distributions concern the results for the long-short portfolio.
presented by Figure V, which displays part of the cumulative portfolio return probability distribution resulting
from the same four model specifications. The squares display the 99.9% VaR-estimates and the 99% and 95%
VaR-estimates can be found where the cumulative probability distribution reaches a cumulative probability of
0.01 and 0.05, respectively. Once more, it is clearly visible that the conditional migration matrix generates the
highest VaR-estimates and holds the highest cumulative probabilities for the most negative portfolio returns.
The cumulative probability distributions do, to some extent, show the small differences between the estimates
generated with the cohort migration matrix relative to those of the duration and AJE migration matrix
68
specifications. Nevertheless, their remarkable similarities dominate the presented picture, especially in the 0.01
to 0.05 cumulative probability range.
The two figures show in essence that the three unconditional migration matrix specifications generate highly
similar results. Even though differences can be found between their VaR-estimates, they are small and likely to
be particularly dependant on the nature of the evaluated portfolios. The differences generated by the
conditional migration matrix are much more apparent. Obviously, these differences are generated by the
stressed nature of the period to which the migration matrix is conditioned. Nevertheless, the whole point of
the conditional matrix is to account for this stressed environment, since these conditions represent the current
market situation at the estimation date. The basic conclusion is that the conditionally of the migration matrix
can generate substantial differences in the VaR-estimates, whereas the estimation methodology of the credit
migration matrix is not likely to do so.
The last specification topic that is discussed with the use of table VII is the copula distribution assumption (or
tail dependence assumption). All model specifications in the table are estimated with the use of each of the
three copula assumptions. The results, when the risk measures resulting from each copula assumption are
compared per specification, are as anticipated. The Gaussian copula, that incorporates no tail dependence,
consistently yields the lowest 99.9% VaR-estimates, while the Student t-copula with the high tail dependence
( 5 ) generates 99.9% VaR-estimates that are 15% higher on average than those resulting from the
Gaussian assumption. The difference is even larger than 20% when the conditional migration matrix is applied
in the estimations of both copula specifications. The VaR-estimates that are generated with the Student tcopula with medium tail dependence ( 15 ) are exactly in between those from the high tail dependence and
no tail dependence specifications. The 99% VaR-estimates show an equivalent pattern, but with a smaller
magnitude. Moreover, all differences between the three different copula assumptions for both the 99.9% and
99% VaR-estimates are highly significant. Lastly, for the 95% VaR-estimates, the pattern only appears for the
long-only portfolio. The long-short portfolio displays more ambiguous results.
FIGURE VI - Cumulative Portfolio Return Probability Distribution: Copula Assumption Comparison
The remaining utilized model specifications are the unconditional duration migration matrix, the credit crisis equity correlation, the equity autocorrelations and the standard liquidity horizons. The estimated distributions concern the results for the long-short portfolio.
Figure VI illustrates the recognized differences in the model estimation results between the three copula
assumptions. The figure presents part of the cumulative portfolio return probability distribution generated by
each of the three copula assumptions for the long-short portfolio. The other underlying inputs are equal for
each distribution curve. Clearly, the differences between the three specifications increase for lower cumulative
probabilities. The cumulative probability distributions display that the left tail experiences a fatness (kurtosis)
similar to the applied copula distribution assumption. In essence, the copula assumption materializes directly
69
in the tails of the portfolio return probability distribution. And since that portfolio return distribution tail is
the main point of interest, it ensures that the copula assumption is of crucial importance in the proposed
incremental risk model. Furthermore, since the correlation inputs are equal in all three estimations, the
differences between the three estimation results are entirely produced by the different assumptions regarding
the nature of the correlations in the model. The large differences signal that the copula distribution
assumption is an essential specification in the model, especially in the estimation of the required 99.9% VaR.
3.1.2 Correlations
The previous section has demonstrated that various assumptions concerning the nature of the issuer asset
correlations in the simulation model can initiate large differences in the resulting VaR-estimates. The next
logical step is to assess the effect of different assumptions regarding the magnitude of the issuer asset
correlations in the model. Accordingly, the equity autocorrelations conditional to the credit crisis and those
conditional to the stable period are employed. Recall that the correlations estimated with credit crisis data are
about twice as high on average as the correlations from the stable period. The implied issuer asset correlations
based on default rates are employed as well. The default rate implied issuer correlations are approximately five
times as low on average as the equity correlations conditional to the stable period data. The remaining inputs,
that are utilized in the model estimations, are once again taken from the general model specification.
One last input variation is applied in this context as well. The unconditional duration credit migration matrix is
used for the stand-alone risk specification in the first model series of model estimations and subsequently the
conditional duration credit migration matrix is applied for the second series of model estimations. The
application of these two migration matrices ensures that the effect of combining both conditional inputs,
conditional stand-alone risk and conditional correlation risk, can be assessed.
The estimation results are displayed in table VIII. Panel A, B and C contain the results that are generated for
the credit crisis correlations, stable period correlation and implied asset correlations based in default rates,
respectively. Herein, the unconditional duration migration matrix is applied as the stand-alone risk. Panel D, E
and F contain the results generated with the same correlation specifications as panel A, B and C, but here the
conditional credit migration matrix is used. All single panels in hold the results for the long-only and the longshort portfolios (L and LS) and within each portfolio the results conditional to each of the three copula
assumptions are given (N, t-5 and t-15). The models estimations, in which the issuer asset correlations based
on default rates are applied, are estimated under the Gaussian assumption only, since the utilized estimation
methodology of these implied asset correlations explicitly relies on that particular assumption.
First, the results that are generated with the unconditional migration matrix (panel A, B and C) are addressed.
The 99.9% VaR-estimates, based on the credit crisis equity correlations (panel A), are consistently and most
often significantly higher than those based on the stable period equity correlations. The magnitude of the
difference is dependent on the portfolio for which the 99.9% VaR-estimate is computed. For the long-only
portfolio, the difference is approximately 5% on average, while it is as low as 2.5% on average for the longshort portfolio. When the 99% VaR-estimates are considered, the significant differences are still existent for
the long-only portfolio (3% on average), while the differences have disappeared for the estimates for the more
realistic long-short portfolio. The results for the long-short portfolio even show higher 95% VaR-estimates
resulting from the stable period equity correlations. In contrast, for the long-only portfolio, the 95% VaRestimates for the credit crisis equity correlation specification are still significantly higher.
70
TABLE VIII - Incremental Risk Model Estimates: Issuer Asset Correlations

A. Credit crisis equity correlations, using the duration migration matrix
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$1.018
$2.013
$1.475
15.42%
30.50%
22.35%
14.96%
29.22%
21.62%
16.04%
31.88%
23.36%
7.00%
12.46%
9.43%
6.86%
12.20%
9.22%
7.14%
12.81%
9.66%
1.60%
2.48%
2.04%
1.54%
2.39%
1.98%
1.66%
2.57%
2.11%
LS
N
t-5
t-15
$0.548
$0.929
$0.713
24.65%
41.74%
32.05%
24.01%
40.36%
31.18%
25.75%
43.13%
33.06%
12.63%
17.28%
14.75%
12.41%
16.88%
14.41%
12.84%
17.67%
15.01%
5.12%
5.07%
5.26%
5.05%
4.96%
5.16%
5.21%
5.19%
5.36%
Portfolio
B. Stable period equity correlations, using the duration migration matrix

L
N
t-5
t-15
99.9%
VaR*
$0.579
$1.664
$1.037
LS
N
t-5
t-15
$0.478
$0.888
$0.638
Portfolio
Copula
99.9%
VaR %
8.78%
25.21%
15.72%
Upper
Bound
8.52%
24.26%
15.22%
Lower
Bound
9.11%
26.62%
16.42%
99%
VaR %
3.89%
9.39%
6.53%
Upper
Bound
3.82%
9.13%
6.38%
Lower
Bound
3.98%
9.60%
6.69%
95%
VaR %
0.69%
1.76%
1.31%
Upper
Bound
0.65%
1.68%
1.25%
Lower
Bound
0.72%
1.84%
1.36%
21.48%
39.90%
28.69%
20.93%
38.47%
27.75%
22.12%
42.26%
29.88%
12.08%
17.43%
14.67%
11.93%
17.04%
14.38%
12.26%
17.81%
14.90%
5.80%
5.85%
6.07%
5.73%
5.74%
5.98%
5.88%
5.97%
6.17%
C. Default rate implied asset correlations, using the duration migration matrix
Portfolio
L
LS
99.9%
VaR*
$0.200
99.9%
VaR %
2.92%
Upper
Bound
2.83%
Lower
Bound
3.03%
99%
VaR %
0.96%
Upper
Bound
0.91%
Lower
Bound
0.99%
95%
VaR %
(0.66%)
Upper
Bound
(0.68%)
Lower
Bound
(0.63%)
$0.354
15.92%
15.54%
16.28%
9.97%
9.85%
10.10%
5.45%
5.40%
5.51%
Copula
D. Credit crisis equity correlations, using duration migration matrix conditional to the credit crisis
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$1.411
$2.862
$2.036
21.38%
43.36%
30.85%
20.90%
41.63%
30.07%
22.22%
45.06%
31.48%
11.59%
18.66%
14.41%
11.37%
18.19%
14.17%
11.81%
19.03%
14.66%
4.93%
6.40%
5.79%
4.84%
6.26%
5.70%
5.00%
6.52%
5.89%
LS
N
t-5
t-15
$0.733
$1.199
$0.928
32.92%
53.89%
41.69%
32.08%
52.01%
40.25%
33.77%
55.74%
43.01%
17.73%
23.37%
20.11%
17.48%
22.93%
19.81%
17.98%
23.90%
20.51%
8.40%
9.04%
8.90%
8.31%
8.90%
8.78%
8.51%
9.18%
9.00%
Upper
Bound
3.38%
5.51%
4.38%
9.28%
9.91%
9.71%
Lower
Bound
3.48%
5.70%
4.51%
9.45%
10.22%
9.94%
Portfolio
E. Stable period equity correlations, using the duration migration matrix conditional to the credit crisis
Portfolio
L
LS
Copula
N
t-5
t-15
N
t-5
t-15
99.9%
VaR*
$0.862
$2.293
$1.416
$0.611
$1.102
$0.836
99.9%
VaR %
13.06%
34.75%
21.46%
27.44%
49.55%
37.58%
Upper
Bound
12.77%
33.63%
20.95%
26.96%
48.26%
36.64%
Lower
Bound
13.42%
35.89%
22.06%
28.00%
51.00%
38.72%
99%
VaR %
7.42%
15.41%
10.75%
17.06%
24.19%
20.00%
Upper
Bound
7.32%
15.09%
10.56%
16.88%
23.73%
19.73%
Lower
Bound
7.54
15.74
10.93
17.26%
24.59%
20.31%
95%
VaR %
3.43%
5.61%
4.45%
9.37%
10.06%
9.82%
F. Default rate implied asset correlations, using the duration migration matrix conditional to the credit crisis
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
$0.407
6.16%
6.02%
6.28%
3.51%
3.46%
3.57%
1.56%
1.54%
1.59%
LS
$0.459
20.63%
20.34%
21.07%
14.15%
13.98%
14.29%
8.60%
8.53%
8.67%
Portfolio
* The 99.9% VaR values are reported in millions. Estimates in between parenthesis signal that the VaR (%) is negative (not a loss, but still a profit
relative to the initial exposure). For the estimates in panel A, B, D and E, equity autocorrelations are used. For the estimates in panel C and F, default
rate implied autocorrelations are used. The applied liquidity horizons are the standard liquidity horizons. Portfolio L is the long only portfolio and
Portfolio LS is the long short portfolio. Copula N is the Normal or Gaussian copula and copulas t-5 and t-15 are the t-Student copulas with underlying
Student t-distributions with 5 and 15 degrees of freedom, respectively. The estimates reported in percentages are relative to the initial portfolio
exposure, which is $6.6 million for the long-only portfolio and $2.225 million for the long-short portfolio. The upper bound and lower bound represent
the 95% confidence interval around the VaR % estimate presented left of them. All estimates are based on 200,000 simulations.
71
In the comparison of the model outputs, generated with the stable period equity correlations and those
computed with the correlations based on default rates, the stable period correlation specification always results
in significantly and substantially higher VaR-estimates when the long-only portfolio is considered. For the
long-short portfolio, the stable period correlation specification generates higher VaR-estimates as well.
Although the difference declines heavily with the VaR confidence interval, it does remain significant.
Panels D, E and F in table VIII display the results of the same model estimations as panel A, B and C. The
difference is that for the stand-alone risk specification, the credit migration matrix conditional to the credit
crisis is employed instead of the unconditional duration migration matrix. The panels display exactly the same
estimation results relative to each other as those in panel A, B and C. The only notable aspect herein is that
the VaR-estimates in panel D, E and F are always significantly higher than those in panel A, B and C, due to
the substantially higher downside migration risk in the conditional migration matrix. Once more, the
conditional stand-alone risk specification generates much higher VaR-estimates than the unconditional
specification.
Figure VII provides an example of the differences in the model estimation results generated with the three
different issuer correlations sets. The figure displays part of the cumulative portfolio return probability
distribution resulting from each issuer correlation set for the long-short portfolio. The remaining model
specification is equal for each curve. The cumulative portfolio return probability distribution computed with
the credit crisis equity correlations is unexpectedly similar to the one resulting from the stable period equity
correlations around the 0.01 to 0.02 cumulative probability range. Moreover, as already mentioned, the
difference is not large at the 0.001 cumulative probability level (the 99.9% VaR) as well. Conversely, the issuer
correlations based on default rates do produce a clearly visible and consistent difference in the left tail of the
cumulative probability curve relative to those resulting from the equity correlation sets.
It may seem counterintuitive that the credit crisis correlations and stable period correlations result in roughly
equal 99% VaR-estimates and only modestly different 99.9% VaR-estimates for the long-short portfolio.
Nevertheless, the observed effect is almost certainly caused by the short positions in the portfolio. Higher
positive issuer asset correlations simply imply that when the long positions experience a scenario with
numerous defaults and downgrades, the short positions are also more likely to default or downgrade. This
effect offers a risk reduction, since these defaults and downgrades ensure that the short positions in the
portfolio generate a relative profit. Even so, it not would be correct to conclude that the average level of the
issuer asset correlations is always likely to only have a small impact on the VaR-estimates in any diversified
long-short portfolio.
FIGURE VII - Cumulative Portfolio Return Probability Distribution: Issuer Asset Correlation Comparison
The remaining utilized model specifications are the Gaussian copula assumption, the unconditional duration migration matrix and the standard liquidity
horizons. The estimated distributions concern the results for the long-short portfolio.
72
Although it is true that higher issuer correlations in an long-short portfolio do not generate the additional risk
that is found for the long-only portfolio, one cannot expect that the risk reducing effect of the short positions
in the long-short portfolio cancels out the effect of increased correlation under any specification for any
portfolio. In other words, one cannot expect both effects to be connected with a perfectly linear relation. The
relation between both effects is highly likely to be portfolio dependent and will certainly be affected by model
parameters such as credit yield curves and the recovery rate as well. In fact, it must be said that when the
standard default value model is applied instead of the modified default value model, the different issuer
correlation sets do generate rate significantly different VaR-estimates for each VaR confidence interval (not
shown).63 Hence, the recovery rate assumption changes the correlation effect. The cumulative portfolio return
probability distribution in figure VII shows signs of a more ambiguous issuer correlation effect as well.
Although very similar in the 0.01 to 0.02 cumulative probability range, the stable period correlation
specification and the credit crisis correlation specification do generate a differently shaped cumulative
probability distribution in the complete range shown in the figure. The different distribution shapes basically
imply that both specifications supply a different risk assessment and thus a correlation effect exists, even
though the VaR-estimates from both model specifications were not all that different.
Lastly, it must be said that the use of issuer asset correlations implied by default rates seems unsuited for the
purpose of the incremental risk model. There is a large probability that it will generate a substantial
underestimation of the true migration and default risk in a credit portfolio. Essentially, such a low average
level of issuer correlations will produce substantially lower VaR-estimates in almost every circumstance.
The next point of interest is the effect of the conditionality in the correlation sets and the migration matrices.
Basically, a stand-alone risk specification conditional to the credit crisis and an unconditional more general
stand-alone risk specification are available. In addition, a correlation risk specification conditional to the credit
crisis and a more general stable period correlation risk specification are available as well.64 One could argue
that the conditional credit migration matrix already effectively captures the clustering of defaults and
downgrades by generating average migration probabilities from a period that can be seen as a default and
downgrade cluster on itself. Furthermore, one could argue as well that the increased collective downgrade
potential is already accounted for in the credit crisis correlations. Essentially, conditioning both risks on the
credit crisis period will generate the same effect twice, resulting in an unwarranted double increase in the
models risk measures. The basic implication of such reasoning is that only one of the inputs should be
conditioned to the credit crisis to account for this market environment. In fact, if all estimates would display
the true underlying values in terms of probabilities and asset correlations and if the relations between the
credit quality levels of the individual issuers were indeed both stable and linear, it should not even matter
which of the two inputs is conditioned to the credit crisis.
The input estimates that were calibrated in Part II obviously do not display the true values. Nevertheless, a
comparison can be made between the model estimation results of the two specifications, where only one of
the two relevant inputs is conditioned to the credit crisis (panel A and panel E in table VIII). Herein, the use
of the conditional credit migration matrix clearly results in a significantly higher model implied risk than the
use of conditional correlations. The conditional credit migration matrix does capture the actual default and
downgrade cluster, whereas the conditional equity correlations attempt to reproduce such a cluster by
introducing high (linear) correlations. Still, the fact remains that the equity correlations are nothing more than
a proxy. The conditional equity correlations do, however, generate a default and downgrade cluster using
issuer-specific information, while the conditional migration matrix employs higher downgrade and default
probabilities that are based on averaging the whole US corporate issuer spectrum. The observed differences
63
64
Recall that the difference between both default value models is that in the standard model the default value is computed as:
Vt Dk ,i rr FVi , while in the modified model it is calculated as: Vt Dk ,i rr Vt CRk ,tik 3 . The effective recovery rate in the model estimation is
much higher when the standard model is employed. Detailed information on both models is provided in Part I section 1.3.3.
The stable period correlations are assumed to provide are a more general display of the issuer asset correlations. The overall level of
the stable period issuer correlations is likely to be reasonably in line with the overall level of unconditional issuer correlations.
73
may therefore be explained by the fact that the conditional credit migration matrix approaches the problem in
a too general form, but more importantly, the conditional equity correlation proxy in combination with the
correlation structure of the model, may not fully capture the actual migration and default correlations.
The main conclusion here is that the decision, regarding which input must be conditioned to the current
market environment (if any), can generate substantial differences in the VaR-estimates that are generated by
the model. In addition, the results indicate that an increase in issuer correlations in a model that employs a
relatively simple linear credit quality correlation structure, does not produce a default and downgrade cluster
equivalent to what is observed in the spectrum of rated issuers. Basically, simple linear correlations are indeed
not likely to fully capture the credit quality relations between issuers.
The last topic to be assessed with the use of table VIII is again the copula assumption. As can be seen in the
table, each model specification is estimated under each of the three copula assumptions. Equivalent
conclusions can be drawn as those presented in the previous section. In essence, the VaR-estimates increase
with the tail dependence of the copula assumption (with the exemption of the 95% VaR-estimates for the
long-short portfolio). Basically, this conclusion holds for all further model estimations and for all remaining
model specifications that will be examined in this study.
A second correlation aspect still to be evaluated, is the effect of incorporating issuer autocorrelations into the
model. Needless to say, the examination of the effect of autocorrelation in the issuer asset returns, and
therefore to some extend the effect of rating drift, provides valuable information regarding the importance of
the incorporating of the observed inefficiency in credit rating dynamics in the incremental risk model.
Table IX displays the generated VaR-estimates of the model with autocorrelations (panel A) and the exact
same model without the incorporation of autocorrelations (panel B). The autocorrelations that are employed
in the computation the VaR-estimates in panel A are the equity autocorrelations based on both the stable
period and the credit crisis period. The models are estimated using the long-only and the long-short portfolio
(L and LS), and once more all three copula assumptions are separately applied and presented (N, t-5 and t-15).
The remaining utilized inputs in the model estimations are those of the general model specification.
TABLE IX - Incremental Risk Model Estimates: Autocorrelations
A. Equity autocorrelations
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$1.018
$2.013
$1.475
15.42%
30.50%
22.35%
14.96%
29.22%
21.62%
16.04%
31.88%
23.36%
7.00%
12.46%
9.43%
6.86%
12.20%
9.22%
7.14%
12.81%
9.66%
1.60%
2.48%
2.04%
1.54%
2.39%
1.98%
1.66%
2.57%
2.11%
LS
N
t-5
t-15
$0.548
$0.929
$0.713
24.65%
41.74%
32.05%
24.01%
40.36%
31.18%
25.75%
43.13%
33.06%
12.63%
17.28%
14.75%
12.41%
16.88%
14.41%
12.84%
17.67%
15.01%
5.12%
5.07%
5.26%
5.05%
4.96%
5.16%
5.21%
5.19%
5.36%
Portfolio
B. No autocorrelation
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$0.937
$1.952
$1.442
14.19%
29.58%
21.85%
13.80%
28.45%
21.14%
14.84%
30.85%
22.79%
6.33%
10.90%
8.95%
6.18%
10.60%
8.71%
6.48%
11.22%
9.12%
1.45%
2.12%
1.84%
1.40%
2.03%
1.77%
1.50%
2.21%
1.91%
LS
N
t-5
t-15
$0.518
$0.854
$0.695
23.26%
38.40%
31.25%
22.68%
36.91%
29.71%
23.86%
40.33%
32.42%
11.76%
16.02%
13.97%
11.51%
15.67%
13.70%
11.97%
16.38%
14.22%
5.03%
4.91%
5.12%
4.95%
4.80%
5.02%
5.09%
5.03%
5.20%
Portfolio
* The 99.9% VaR values are reported in millions. All estimates are based on the duration migration matrix and credit crisis period equity correlations.
The applied liquidity horizons are the standard liquidity horizons. Portfolio L is the long only portfolio and Portfolio LS is the long short portfolio.
Copula N is the Normal or Gaussian copula and copulas t-5 and t-15 are the t-Student copulas with underlying Student t-distributions with 5 and 15
degrees of freedom, respectively. The estimates reported in percentages are relative to the initial portfolio exposure, which is $6.6 million for the longonly portfolio and $2.225 million for the long-short portfolio. The upper bound and lower bound represent the 95% confidence interval around the
VaR % estimate presented left of them. All estimates are based on 200,000 simulations.
74
FIGURE VIII - Cumulative Portfolio Return Probability Distribution: Autocorrelation Comparison
The remaining utilized model specifications are the Gaussian copula assumption, the unconditional duration migration matrix, the credit crisis period
equity correlations and the standard liquidity horizons. The estimated distributions concern the results for the long-short portfolio.
In the comparison between the VaR-estimates in panel A and panel B (for all VaR confidence intervals), it is
clearly visible that the incorporation of autocorrelation in the proposed incremental risk model results in
slightly higher VaR-estimates for all the separate model specifications in the table. The differences are
significant about half of the times, but the effect is incredibly consistent. Recall that the average
autocorrelation coefficient was 0.04, with a maximum of 0.33 and a minimum of -0.33. The average is
positive, but remarkably low as well. The positive nature of the average autocorrelation coefficients explains
why the VaR-estimates all have increased as a result of the incorporation of autocorrelation. In essence,
positive autocorrelation ensures that when the simulation of a single-period in the multi-period model
produces a relatively poor scenario, the subsequent period is more likely to result in a poor scenario as well.
Note, however, that this effect also occurs for the short positions, reducing the increase in the VaR-estimates.
Consequently, the increase in the VaR-estimates due to the incorporation of autocorrelation is relatively
smaller in the long-short portfolio. Figure VIII illustrates the small but consistent difference between the
results of the autocorrelation and the no-autocorrelation specifications. The cumulative portfolio return
probability distribution is always slightly higher for the model with autocorrelation. Thus, the probability of
more negative portfolio returns is slightly higher when the model incorporates autocorrelation.
The effect of the autocorrelation in the model estimates is quite small. It does, however, demonstrate that an
additional low correlation in the time-series dimension in the model induces visible and consistent effects on
all VaR-estimates. In a portfolio with more positively auto-correlated issuer asset returns, the incorporation of
autocorrelation will definitely gain importance in the model.
3.1.3 Liquidity Horizons
The next topic, in the discussion of the model estimations, is the examination of the effect of liquidity horizon
assumptions in the model. The concept of the liquidity horizon was introduced by the Basel Committee to
ensure the capital requirements for less liquid credit products are relatively higher. Consequently, it would be
prudent to examine whether the proposed incremental risk model displays this characteristic or not. Such an
examination is achieved by comparing the model results that are generated with the equivalent model
specifications, but with different liquidity horizon assumptions. Herein, three sets of liquidity horizon
assumptions are employed. The general case uses the standard liquidity horizons as described in Part II section
2.3.2. The second specification is the low liquidity horizon specification, where the liquidity horizons of all
positions in the portfolios are reduced by three months with a minimum liquidity horizon of three months.
The third specification is the high liquidity horizon specification, where the liquidity horizons of all positions
75
in the portfolios are increased by three months with a maximum liquidity horizon of one year. For all three
models, the remaining inputs from the general model specification are utilized.
TABLE X - Incremental Risk Model Estimates: Liquidity Horizons
A. Low liquidity horizons
Portfolio
L
LS
Copula
N
t-5
t-15
N
t-5
t-15
99.9%
VaR*
$0.669
$1.537
$1.004
$0.382
$0.678
$0.504
99.9%
VaR %
10.14%
23.29%
15.21%
17.18%
30.49%
22.65%
Upper
Bound
9.89%
22.53%
14.78%
16.63%
29.33%
22.13%
Lower
Bound
10.53%
24.48%
15.82%
17.73%
31.64%
23.42%
99%
VaR %
4.39%
8.78%
6.34%
8.63%
12.61%
10.61%
Upper
Bound
4.29%
8.51%
6.20%
8.50%
12.34%
10.41%
Lower
Bound
4.51%
9.05%
6.52%
8.80%
12.96%
10.85%
95%
VaR %
0.52%
1.31%
1.01%
3.41%
3.65%
3.78%
Upper
Bound
0.48%
1.24%
0.96%
3.35%
3.56%
3.71%
Lower
Bound
0.57%
1.38%
1.07%
3.46%
3.73%
3.85%
B. Standard liquidity horizons

Portfolio
L
LS
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
N
t-5
t-15
$1.018
$2.013
$1.475
$0.548
$0.929
$0.713
15.42%
30.50%
22.35%
24.65%
41.74%
32.05%
14.96%
29.22%
21.62%
24.01%
40.36%
31.18%
16.04%
31.88%
23.36%
25.75%
43.13%
33.06%
7.00%
12.46%
9.43%
12.63%
17.28%
14.75%
6.86%
12.20%
9.22%
12.41%
16.88%
14.41%
7.14%
12.81%
9.66%
12.84%
17.67%
15.01%
1.60%
2.48%
2.04%
5.12%
5.07%
5.26%
1.54%
2.39%
1.98%
5.05%
4.96%
5.16%
1.66%
2.57%
2.11%
5.21%
5.19%
5.36%
C. High liquidity horizons

Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
$1.407
$2.618
$1.921
21.31%
39.66%
29.11%
20.41%
39.09%
28.21%
22.14%
40.66%
30.13%
9.48%
16.06%
12.07%
9.26%
15.69%
11.83%
9.72%
16.43%
12.34%
2.80%
3.71%
3.31%
2.73%
3.59%
3.21%
2.88%
3.82%
3.41%
LS
N
t-5
t-15
$0.712
$1.149
$0.891
32.02%
51.62%
40.02%
31.21%
49.97%
39.02%
32.92%
54.21%
41.79%
16.09%
21.53%
18.31%
15.82%
21.04%
18.04%
16.38%
22.04%
18.63%
6.85%
6.83%
6.92%
6.75%
6.71%
6.81%
6.96%
6.97%
7.04%
Portfolio
* The 99.9% VaR values are reported in millions. All estimates are based on the duration migration matrix, credit crisis period equity correlations and
equity autocorrelations. Portfolio L is the long only portfolio and Portfolio LS is the long short portfolio. Copula N is the Normal or Gaussian copula
and copulas t-5 and t-15 are the t-Student copulas with underlying Student t-distributions with 5 and 15 degrees of freedom, respectively. The estimates
reported in percentages are relative to the initial portfolio exposure, which is $6.6 million for the long-only portfolio and $2.225 million for the longshort portfolio. The upper bound and lower bound represent the 95% confidence interval around the VaR % estimate presented left of them. All
estimates are based on 200,000 simulations.
The estimation results are displayed in table X. Panel A presents the results for the low liquidity horizon
model specification. Panel B displays the estimates generated by the standard liquidity horizon specification
and panel C holds the estimates resulting from the high liquidity horizon model specification.
In the comparison of the VaR-estimates between the three specifications, clear differences can be found. As
one would anticipate, the low liquidity horizon specification always generates the smallest VaR-estimates,
while the high liquidity horizon specification always produces the largest VaR-estimates. When the 99.9%
VaR-estimates are considered, the liquidity horizons effect is very substantial. For the long-only portfolio, the
difference between the 99.9% VaR-estimates resulting from the low liquidity horizon model and the standard
liquidity horizon model is 6% on average, and the difference between the estimates from the standard liquidity
horizon model and the high liquidity horizon model is 7.5% on average. The long-short portfolio displays an
average difference of 9.5% between the estimates from the low liquidity horizon model and the standard
liquidity horizon model, while an average difference of 8.5% can be found between the estimates resulting
from the standard liquidity horizon model and those of the high liquidity horizon model. All these differences
are highly significant.
76
In the case of the 99% VaR and the 95% VaR, similar significant differences of a smaller magnitude can be
found. The magnitude of the differences basically declines again with the VaR confidence interval.
The effects of the different liquidity
FIGURE IX - Portfolio Return Probability Distribution
horizons assumptions are graphically
displayed in figure IX and figure X. The
figures present the left tail of the portfolio
return probability distribution and
cumulative portfolio return probability
distribution, respectively, for the longshort portfolio, resulting from each of the
three liquidity horizon assumption sets.
The
remaining
underlying
model
specification is the equal for the three
probability curves in each figure. Figure
IX sets forth a clear picture, since it
demonstrates that the likelihood of larger
losses is visibly higher when the liquidity
horizons are increased. Figure X confirms
The remaining utilized model specifications are the Students t-15 copula
this statement for the cumulative
assumption, the unconditional duration migration matrix, the credit crisis period
probability distribution. In essence, the
equity correlations and the equity autocorrelations. The estimated distributions
concern the results for the long-short portfolio. The portfolio return probability is
figures reveal that the left tail of both the
equal to the frequency divided by 200,000 (the number of simulations).
portfolio return probability distribution
and the cumulative portfolio return
probability distribution is highly sensitive to the liquidity horizon assumption set, underlying the evaluated
portfolio. The portfolio return decreases drastically for a given cumulative probability, or VaR confidence
interval, when the liquidity horizons of the positions in the portfolio are enlarged. The main conclusion, based
on the estimation results and both figures, is that a modest change in the liquidity horizon assumption set
produces substantial variations in the relevant VaR-estimates or in more general terms, the models risk
measures. As a consequence, a credit portfolio that is assumed to be less liquid will definitely generate a higher
99.9% VaR measure, which is entirely consistent with the objectives underlying the concept of the liquidity
horizon. Hence, the liquidity horizon must be considered a crucial input in the model.
FIGURE X - Cumulative Portfolio Return Probability Distribution: Liquidity Horizon Assumption Comparison
The remaining utilized model specifications are the Students t-15 copula assumption, the unconditional duration migration matrix, the credit crisis
period equity correlations and the equity autocorrelations. The estimated distributions concern the results for the long-short portfolio.
77
3.1.4 Concentrated Positions

The last model specification topic to be discussed is the effect of concentrated positions in the portfolio.
Although concentrations are not actually inputs that require estimations or calibrations, it is informative as
well as critical to make an assessment of the effects of concentrations on the risk measures of the model. The
Basel Committee states that the effects of issuer concentrations and market concentrations should be captured
in the incremental risk model. The assessment of the portfolio with concentrated positions (the concentrated
portfolio) allows for the examination of the effect in the model of issuer concentrations in the form of two
large positions in the portfolio. For this purpose, various model specifications are applied again. These
different models are estimated for both the long-short portfolio (LS) and for the long-short portfolio with
concentrated positions (LS-C).
The net and absolute exposure of both portfolios is equal, as well as the relative and absolute long and short
exposure to each credit rating. This equivalence ensures that the VaR-estimates resulting from both portfolios
can be directly compared. The only additional difference between both portfolios is that the liquidity horizons
of the two concentrated positions are increased by three months in the concentrated portfolio. Apart from the
direct comparison of the results generated by both portfolios, the second objective is to examine whether the
conclusions highlighted in the previous sections still apply for the concentrated portfolio.
Four different model specifications are estimated for both portfolios and for all three copula assumptions.
The results are shown in table XI. The estimates in panel A are computed with the use of the unconditional
duration migration matrix, the credit crisis equity correlations and equity autocorrelations. The panel B
estimates are generated using of the duration migration matrix conditional to the credit crisis, the credit crisis
equity correlations and equity autocorrelations. The panel C estimates employ the unconditional duration
migration matrix, the stable period equity correlations and equity autocorrelations. Lastly, the panel D
estimates are the result of the application of the unconditional duration migration matrix and the credit crisis
equity correlations. Hence, issuer autocorrelation is not incorporated in this last specification.
In the comparison of the two portfolios for each model specification, it is very clear that the concentrated
portfolio generates much higher VaR-estimates. Large and significant differences between the estimates of the
long-short portfolio and the concentrated portfolio are observed for all different model specifications. The
99.9% VaR-estimates display a difference, ranging from 5.5% to 13%. The 99% VaR-estimates show an
average difference 9% in favour of the concentrated portfolio. Lastly, the difference in the 95% VaR-estimates
ranges from 3% to 6.5%. The conclusion is extremely clear. The effect of the introduction of concentrated
positions in the long-short portfolio is rather large. Obviously, the large differences that can be found in the
VaR-estimates are dependent on the applied definition of concentrated positions and would have been smaller
in magnitude if the concentrated positions would have been relatively smaller. Also note that the increase in
the VaR-estimates generated for the concentrated portfolio are partially due to the increased liquidity horizons
of the concentrated positions. Nevertheless, the VaR-estimates undoubtedly show that the model implied risk
is relatively sensitive to concentrations.
In essence, a concentration is nothing more than a set of highly correlated positions or perfectly correlated
positions when one large position is considered as the concentration. Therefore, the conclusions drawn on the
subject apply to market concentrations as well, but to a smaller extent (i.e. the effects are smaller for market
concentrations). The additional risk induced by market concentrations is simply caused by much higher than
average correlations. A further increase of the model implied risk may be induced by higher liquidity horizon
assumptions for the positions that are part of the market concentration. Similar to issuer concentrations, these
positions are likely to require more time to be sold or hedged in an economic downturn than positions that are
not part of a concentration of any type.
The second aspect that is addressed with the use of table XI, are the conclusions that have been drawn in the
previous sections. Basically, the model estimations, under the various parameter specifications, allow for a
second assessment of the previous topics in the context of the portfolio with concentrated positions. In
essence, the estimations show whether these conclusions are robust to the concentrated portfolio.
78
The conditionality in the stand-alone risk specification can be assessed again with the use of the estimations in
panel A and panel B. The VaR-estimates in panel A and B are generated with the exact same model
specification, yet in panel A the unconditional duration migration matrix is applied, whereas in panel B the
migration matrix conditional to the credit crisis is employed. In the comparison of both model specifications
for the concentrated long-short portfolio, it is evident that the conclusion is the equal to the one drawn in
section 3.1.1. Once again, the application of conditional migration matrix yields significantly higher risk
estimates. Even the magnitude of the differences for each VaR confidence interval is roughly equal, compared
to those generated for the regular long-short portfolio.
TABLE XI - Incremental Risk Model Estimates: Concentrations
A. Duration matrix, credit crisis equity correlations and equity autocorrelations
LS
N
t-5
t-15
99.9%
VaR*
$0.548
$0.929
$0.713
LS-C
N
t-5
t-15
$0.804
$1.133
$0.939
Portfolio
Copula
99.9%
VaR %
24.65%
41.74%
32.05%
Upper
Bound
24.01%
40.36%
31.18%
Lower
Bound
25.75%
43.13%
33.06%
99%
VaR %
12.63%
17.28%
14.75%
Upper
Bound
12.41%
16.88%
14.41%
Lower
Bound
12.84%
17.67%
15.01%
95%
VaR %
5.12%
5.07%
5.26%
Upper
Bound
5.05%
4.96%
5.16%
Lower
Bound
5.21%
5.19%
5.36%
36.15%
50.90%
42.19%
35.48%
49.68%
40.76%
36.79%
52.61%
43.59%
22.54%
26.13%
24.30%
22.22%
25.74%
23.88%
22.82%
26.52%
24.62%
9.45%
8.56%
9.14%
9.27%
8.35%
8.94%
9.62%
8.80%
9.33%
B. Duration matrix conditional to the credit crisis period, credit crisis equity correlations and equity autocorrelations
Portfolio
LS
LS-C
Copula
N
t-5
t-15
N
t-5
t-15
99.9%
VaR*
$0.733
$1.199
$0.928
$0.958
$1.303
$1.080
99.9%
VaR %
32.92%
53.89%
41.69%
43.04%
58.57%
48.56%
Upper
Bound
32.08%
52.01%
40.25%
42.23%
57.27%
47.44%
Lower
Bound
33.77%
55.74%
43.01%
44.22%
60.86%
50.16%
99%
VaR %
17.73%
23.37%
20.11%
28.18%
31.74%
29.98%
Upper
Bound
17.48%
22.93%
19.81%
27.95%
31.32%
29.68%
Lower
Bound
17.98%
23.90%
20.51%
28.49%
32.14%
30.31%
95%
VaR %
8.40%
9.04%
8.90%
14.93%
15.24%
15.20%
Upper
Bound
8.31%
8.90%
8.78%
14.75%
14.98%
14.98%
Lower
Bound
8.51%
9.18%
9.00%
15.11%
15.46%
15.40%
C. Duration matrix, stable period equity correlations and equity autocorrelations

Portfolio
LS
LS-C
Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
N
t-5
t-15
N
t-5
t-15
$0.478
$0.888
$0.638
$0.765
$1.021
$0.891
21.48%
39.90%
28.69%
34.37%
45.90%
40.02%
20.93%
38.47%
27.75%
33.85%
44.36%
39.44%
22.12%
42.26%
29.88%
35.16%
47.53%
40.95%
12.08%
17.43%
14.67%
22.14%
25.70%
24.09%
11.93%
17.04%
14.38%
21.82%
25.30%
23.78%
12.26%
17.81%
14.90%
22.46%
26.11%
24.41%
5.80%
5.85%
6.07%
9.63%
8.61%
9.67%
5.73%
5.74%
5.98%
9.48%
8.39%
9.48%
5.88%
5.97%
6.17%
9.78%
8.81%
9.85%
D. Duration matrix, credit crisis equity correlations and no autocorrelations

Copula
99.9%
VaR*
99.9%
VaR %
Upper
Bound
Lower
Bound
99%
VaR %
Upper
Bound
Lower
Bound
95%
VaR %
Upper
Bound
Lower
Bound
LS
N
t-5
t-15
$0.518
$0.854
$0.695
23.26%
38.40%
31.25%
22.68%
36.91%
29.71%
23.86%
40.33%
32.42%
11.76%
16.02%
13.97%
11.51%
15.67%
13.70%
11.97%
16.38%
14.22%
5.03%
4.91%
5.12%
4.95%
4.80%
5.02%
5.09%
5.03%
5.20%
LS-C
N
t-5
t-15
$0.780
$1.031
$0.882
35.05%
46.33%
39.65%
34.58%
45.24%
38.77%
35.74%
48.00%
40.59%
21.31%
25.27%
23.06%
21.03%
24.89%
22.68%
21.58%
25.69%
23.39%
8.98%
8.32%
8.87%
8.82%
8.11%
8.67%
9.15%
8.53%
9.04%
Portfolio
* The 99.9% VaR values are reported in millions. Portfolio LS is the long-short portfolio and portfolio LS-C is the long-short portfolio with
concentrated positions. Copula N is the Normal or Gaussian copula and copulas t-5 and t-15 are the t-Student copulas with underlying Student tdistributions with 5 and 15 degrees of freedom, respectively. The applied liquidity horizons are the standard liquidity horizons for the LS portfolio. For
the LS-C portfolio, the standard liquidity horizons also used, but the liquidity horizons of the two concentrated positions are increased by three months.
The estimates reported in percentages are relative to the initial portfolio exposure, which is $2.225 million for both the long-short portfolio and the
long-short portfolio with concentrated positions. The upper bound and lower bound represent the 95% confidence interval around the VaR % estimate
presented left of them. All estimates are based on 200,000 simulations.
79
The second topic that is assessed again is the effect of increased issuer correlations. The estimates in panel A
and C are generated with the credit crisis equity correlations and the stable period equity correlation,
respectively. The remaining model specifications per copula assumption are equal for the estimates in the two
different panels. The effect of increased correlations that was found in section 3.1.2 for the long-short
portfolio was only moderate for 99.9% VaR. No detectable effect was found for the 99% VaR-estimates,
while the credit crisis correlations are roughly twice as high on average. Nonetheless, the shape of the
cumulative portfolio return probability distribution resulting from both correlations sets did show some
suspicious differences. In comparison of the 99.9% and 99% VaR-estimates in panel A and C for the
concentrated portfolio, the exact same conclusion can be found again. The credit crisis correlation set
generates a moderately and mostly significantly higher 99.9% VaR, while no single significant difference can
be detected of 99% VaR-estimates. Yet again, these VaR-estimates imply that the cumulative portfolio return
probability distributions generated by the two different correlation sets display the same dissimilarities as those
of the regular long-short portfolio. Once more, the effect of increased issuer correlations seems quite weak for
the required risk measure (the 99.9% VaR). Nevertheless, this observation certainly does not imply that this
will be the case for any portfolio and any set of model parameters.
The last topic that is discussed with the use table XI, is the effect of autocorrelations. A comparison of panel
A and D for the concentrated portfolio per copula assumption assesses this particular effect once again.
Similar to the previous two topics, the effect for the concentrated portfolio is in line with the findings for the
regular long-short portfolio that where highlighted in the previous sections. The VaR-estimates resulting from
the simulation model without autocorrelations are slightly and mostly significantly smaller than those
generated with the simulation model where autocorrelation is incorporated. The effect is consistent over all
the VaR confidence intervals and copula distribution assumptions.
It seems that the long-short portfolio, apart from its additional concentration or correlation risk, is subject to
the exact same effects as the regular long-short portfolio. Although the results do not imply that the effects
are equal for every possible portfolio, their consistency does provide the necessary additional strength and
robustness to the conclusions presented in the previous sections.
3.2
INTERPRETATIONS, EXTENSIONS AND LIMITATIONS

In the previous section, a large number of models have been estimated under various assumptions and with
the use of multiple alternative inputs. The results generate a quite clear picture on the workings of the
proposed model. The next topic is the interpretation of the model estimation results in the form of an
assessment of the most crucial inputs and assumptions in the model. Apart from the inputs and assumptions
highlighted in the model estimations, multiple additional inputs and assumptions also play a role in the model.
Therefore, after the identification of the most crucial inputs and assumptions, the major components of the
model will be addressed once again. Herein, limitations or additional assumptions and possible extensions or
improvements of these specific model components are the key topics. Moreover, it is also important to point
out whether or not the conclusions, based on the model estimations and interpretations, are likely to apply to
the incremental risk model in general. Hence, this aspect will be addressed where relevant. The section is
completed with an elaboration of the position of the incremental risk model within the Basel II Market Risk
Framework and an assessment of the issues that are introduced by the new definition of market risk capital in
this Market Risk Framework.
3.2.1 Crucial Inputs and Assumptions

The majority of observed effects of the various specifications in the model estimations were as anticipated.
Those that were not, proved easily explainable. Consequently, the model yields intuitively appealing results. In
addition, the set-up of the model is built on the CreditMetrics model and has largely preserved its intuition.
Obviously, these two aspects do not ensure that the model is validated for its purpose, yet they do imply that
the constructed simulation framework performs as it was intended to do.
80
Furthermore, the assessment in the previous section ensures that the most important components in the
development of an incremental risk model can be identified (i.e. which components generate the largest
relative effect in such a model). Implications as such are clearly relevant in the regulation, validation and
modelling context. When the most critical inputs and assumptions are identified, an overview can be produced
with reference to where particular attention may be considered necessary. Regulators may use such
information to determine which parts of the model require additional guidance or restrictions, and to detect
whether or not a model of this kind performs in way that is consistent with their objectives. Model developers
may use it to identify where emphasis is required in the construction of a model, and in the validation context
the information may be directly useful in the determination of which assumptions and inputs require the most
attention and demand the highest standards in the validation process.
Based on the estimation results of the previous section, a list of the model assumptions and inputs in order of
importance can be constructed. This list is presented below and comprises the seven main components of the
model that were addressed in the estimations. The first four components are the most critical.
1. Copula distribution assumption: The most essential assumption or input in the model is the copula
distribution assumption. Each series of model estimations has demonstrated that large differences in the
model implied risk can be generate with different copula assumptions. Moreover, these large differences are
robust to a wide variety of model specifications. Essentially, it seems that the nature of the relations between
the individual positions in a credit portfolio is more important than the exact magnitude of these particular
relations. Herein, the often applied simple Gaussian models do not account for the likely tail dependence in
asset returns (or credit quality in general), and therefore a Gaussian copula specification will almost certainly
underestimate the migration and default risk of the entire trading portfolio. For example, the model implied
risk that is generated with the much more realistic Students t-copula specification with 15 degrees of freedom,
which incorporates an intermediate degree of tail dependence, is still much higher than the implied risk
resulting from the Gaussian model.
Furthermore, simulation is the most probable way in which any incremental risk model will be constructed. In
addition, risk relations must be specified by correlation coefficients according to the Incremental Risk Capital
Charge guidelines. Consequently, a copula assumption of some kind is likely to be made in such a model. This
implies that any copula related conclusion is relevant in the general incremental risk model context. In fact, the
copula conclusions based on the model estimations almost certainly apply in general as well. Hence, in
practice it is critical that the actual asset return distributions of the relevant issuers and their correlations, albeit
on an average level, are examined in order to find the proper copula specification.65
2. Conditionality: The second most critical aspect in the proposed incremental risk model is the
conditionality of the risks in the model. The two main risks components, the stand-alone risk and the
correlation risk, can both be conditioned on specific economic environment or time period. Especially, the
stand-alone risk in the form of a credit migration matrix is crucial in this respect. The credit migration matrix
conditioned to the credit crisis yields consistently and substantially higher model implied risk measures than a
more general unconditional migration matrix based on 20 years of historical data. This statement holds for
both the long-short and long-only portfolio and applies under wide variety of additional model specifications.
The example is obviously quite extreme, but the results are remarkably clear. Hence, as one would expect, an
incremental risk model is highly likely to be incredibly sensitive to the conditionality applied in its inputs.
Essentially, in any incremental risk model a decision has to be specified regarding the economic conditions or
the time period to which the inputs of the model will to be conditioned. Herein, the at that point in time
relevant credit migration matrix should be applied, yet this should also be consistent with the general objective
65
Mashal & Zeevi (2002), An & Kharoubi (2003), Abid & Naifar (2007) and Genest et al. (2009) for example, are four of the many
papers on the copula subject (in the risk management context), discussing various methodologies of fitting copulas to empirical
datasets and proposing goodness-of-fit tests to approach their performance. Trivedi & Zimmer (2005) and Nelson (2006) provide a
more general assessment of copula estimation procedures in econometrics.
81
and intuition of the incremental risk model. The same applies to the correlations that are applied in the model,
but to a much smaller extend. The conditionally issue will be discussed extensively in section 3.2.4.
3. Liquidity horizons: The length of the liquidity horizons of the positions in the model is another crucial
input/assumption in the incremental risk model. The implied risk estimates of the proposed model are
relatively sensitive to the assumed liquidity horizons lengths, as a modest increase in all the liquidity horizons
generated a substantial increase in the model implied risk. It is not unlikely that effects as such will be present
in actual incremental risk models, since the liquidity horizons and the constant risk assumption are
incorporated into the proposed model in accordance with the Basel Committees requirements. An actual
incremental risk model may follow a similar approach with respect to the constant risk assumption and is
likely to produce similar results for that matter. Thus, a credit portfolio that is assumed to be less liquid will
almost certainly be subject to a higher Incremental Risk Capital Charge in practice.
Apart from the theoretical ambiguity surrounding the constant risk assumption, the current incremental risk
model proposal of the Basel Committee will accentuate the importance of the liquidity of trading positions,
which is as stated by Finger (2009) a worthy goal in its own right in the light of recent events. An additional
component that is still required, however, is an accurate methodology to estimate the length of the liquidity
horizon of the positions in the trading portfolio. This is obviously a subject of further research and discussion.
4. Average issuer correlation level: The period or economic environment, to which the issuer correlations in
the model are conditioned, plays a vital role as well. Although the two different periods applied in this study
did yield very different average correlations, the implications of these differences in the more realistic longshort were only marginal when compared to the effects of copula assumption for example. Nonetheless, this
observation is not likely to apply in general. Basically, the reduced increase in the models risk measures only
applies for trading portfolios with a substantial proportion of short positions, where the long and short
positions are of a very similar nature. More specifically, the risk reduction provided by the short positions in a
high correlation environment will exist only when the short positions exhibit a value loss similar to the long
positions in the worst simulation scenarios.66 In practice, however, one cannot assume this will always apply
and therefore it is essential that the average correlation level is displayed accurately. Moreover, when the effect
does exist, it is not realistic to assume it will always largely cancel out the effect of increased correlations on
the long positions. The magnitude of the risk reducing effect of the short positions is likely to be highly
dependent on the applied credit yield curves and the recovery rate, since these inputs determine the actual
losses or gains in the portfolio as a result of downgrades, upgrades or defaults.
Furthermore, evidence for the importance of accurately capturing the average level of issuer correlations can
be found in the fact that the comparison between the results of the almost no issuer correlation (correlations
implied by default rates) specifications and the stable period issuer correlation specifications did yield in a
consistent and substantial difference in the models risk measures. An even larger effect induced by increased
correlations was found for the long-only portfolio, due to the fact that the risk reducing effect is not present
in the long-only portfolio. Consequently, the average level of the issuer correlations is a key component of the
proposed model and therefore of the incremental risk model in general as well. The precision of the all the
underlying individual correlation coefficients, however, seems to be of much less importance. Basically, it is
the aggregate correlation effect that may significantly influence the model implied risk, whereas differences in
individual correlation estimates in a large portfolio are much too inconsequential to induce such an effect.
Lastly, in a large trading portfolio with numerous different credit products, there may be correlation effects
that are not completely captured by one single average level of issuer correlations. In this case, it would be
prudent to assess the correlations in the portfolio as averages within and between industries or within and
between product types.
66
The asymmetries of possible optionality in a trading portfolio, for example, may distort the risk reduction provided by short
positions in a high correlation market environment.
82
5. Autocorrelation: The issuer-specific autocorrelation introduced in the issuer asset returns is an aspect of
moderate importance in the proposed incremental risk model. Its incorporation into the model led to a
relatively small increase in the model implied risk that was robust to the three different copula assumptions,
three different portfolios and three different VaR confidence intervals. Herein, it must be noted that the
applied autocorrelations inputs were relatively low. Consequently, the model implied risk seems to be quite
sensitive to autocorrelation. In practice, however, the magnitude of autocorrelations is likely to be not high as
well and therefore it is not likely that autocorrelations will produce large effects within the model. If the
decision is made to incorporate it, then a small or modest effect will be introduced with respect to the models
risk measures, depending on the magnitude of the estimated autocorrelation inputs. This statement is rather
certain for the proposed model and is also likely to apply to a reasonable extent in general to any proposed
incremental risk model that incorporates issuer-specific autocorrelation.
6. Issuer-specific correlations: The second least important input, of the inputs that were evaluated in the
previous section, is the specific value of the correlation coefficients between the issuers in the portfolio.
Essentially, in a relatively simple diversified portfolio with substantial short positions, an increase in the
average level of the issuer correlation only produced a small increase in the model implied risk. Obviously, this
does not apply to all possible credit portfolios, but it does shift the attention from specific individual
correlation coefficients to the more general average level of issuer correlations. Hence, all specific correlation
coefficients between all issuers will only have to be approximations of true value, as long as the average
correlation level is displayed correctly.
Furthermore, the specific issuer correlations underlying large or concentrated positions may required more
precise estimates, as concentrations can generate a large increase in the models risk measures, as observed in
the model estimations in section 3.1.4. Basically, when issuer correlations within market concentrations are not
correctly displayed, the concentrations may not be recognized as such. Especially market concentrations or
issuer concentrations that only contain long or only short positions require additional attention. The risk
reducing effect, that is introduced by high correlations and occurs in the opposite side of the portfolio, will
not be present in concentrations of this kind.
7. Credit migration matrix estimation methodology: The least important evaluated input aspect of the model is
the credit migration matrix estimation methodology. Unlike the conditionality imposed into the credit
migration matrix, the different methodologies in the estimation of the migration matrices are not likely to
generate substantial differences in the model implied risk. Only for portfolios with large quantities of lower
rated positions (BB, B and CCC/C) substantial differences may emerge as a result of the application of
different methodologies. In general, one may prefer the duration methodology, since it employs all relevant
information in the most efficient way and has numerous practical or technical advantages as well. Moreover,
when a more detailed conditional stand-alone risk specification is required, the duration methodology is the
only of the three estimation methods that allows for the estimation of the required parameters and their
statistical properties in such a more complicated risk specification.
One important model input is missing in this list. That is, the applied recovery rate is a crucial input as well.
The effect of changing this input has not been addressed in the model estimations, since this effect is quite
straightforward and its inclusion would extent the scope of this study even further to an unwarranted level.
Basically, the recovery rate determines the (average) loss (or gain for a short position) as a result of a simulated
default in the model. The loss as a result of default can generally be considered as the largest possible value
change for a single position due to a (single rating class) change in credit quality, as the expected magnitude of
this change is larger than any possible value change generated by a one rating class downgrade or upgrade.
Hence, a lower (higher) recovery rate will increase (decrease) the models risk measures, since defaults play a
crucial role in the extremely poor simulation scenarios from with the required risk measure is taken. This
statement is confirmed by the fact that when the standard default value model is employed in the model
estimations, instead of the modified version of the default value model, the all VaR-estimates decrease
83
drastically.67 Recall that the difference between both default value models is that the standard model employs a
much higher effective recovery rate. In summary, in the construction and estimation of an actual incremental
risk model, one must place great emphasis on the recovery rate assumption as well.
Apart from the model components or aspects discussed above, there are obviously more inputs and
assumptions underlying the proposed model or an incremental risk model in general. In the model
estimations, however, the decision has been made to focus on this set of inputs, since they are regarded to be
the most imperative to the model in general. In addition, apart from possibly the credit yields curves, there are
no remaining inputs that are likely to have an impact on the models risk measures as large as any of the
components addressed in this section. Section 3.2.2 to 3.2.6 will assess the major components of the model
once more, and here many of additional assumptions, limitations and possible improvements are addressed to
complete the assessment of the proposed model.
3.2.2 The Scope of the Exercise
The first aspect to be evaluated, is the scope of the model estimations that were presented in section 3.1. This
scope is quite limited, since the assessed portfolios only contain corporate bonds. Even so, the model does
yield realistic results. In that sense, it is not too hard to imagine how the model may behave when portfolios of
multiple different credit products would be assessed with the model. Although such an exercise is beyond the
scope of the study, it is a recommended extension to the exercise presented in this study. Moreover, the
assessed corporate bond portfolios were designed to display the characteristics of an average corporate bond
portfolio, such that its implications can evaluated in general context. Even though such a general view in the
evaluation of the model is warranted, its implications may not be completely extendable to more specific
cases. Examples obviously are portfolios containing multiple different credit product classes or portfolios
made up entirely by a single other type of credit product.
One can be fairly certain that the model will behave very similar to what was observed in the previous section
in terms of the importance of the components in the model, when it is applied to a mainly speculative grade
corporate bond portfolio, for example. However, when it comes to the application of a portfolio containing
different types of credit products, only reasonable expectations can be formed in this context. It is rather
certain that the importance of the copula assumption, conditionality and the liquidity horizon specification can
be generalized to almost every possible scenario. The average level of issuer correlation, however, may induce
substantially different effects in different portfolios. For instance, when some form of optionality is present in
the majority of short positions in the portfolio, the risk reducing effect of the short positions in a high
correlation environment may not exist at all. In that case, the importance of accurately capturing the issuer
correlation effect must be seriously amplified. Furthermore, it is not unlikely that the issuer-specific
autocorrelations, the estimation method of the credit migration matrix and even the specific correlation
coefficient values may gain importance in alternative scenarios.
A second aspect related to the scope of the exercise in the study is a point-in-time model assessment. In such
an assessment, one evaluates how the model would behave through time, as the model would be estimated for
many different estimation dates. The output can then be utilized to construct a measure of the risk implied by
the model in a time-series dimension, which can subsequently be compared to a benchmark of some kind.
Obviously, such a procedure would enhance the understanding of the workings of the proposed model, but it
is a very time time-consuming addition to the study as well. Hence, the decision has been made to not
perform such an assessment. Basically, in each estimation the credit yield curves have to be replaced in the
67
The models have also been estimated with the use of the standard default model. Yet they are not presented in this study to limit
the size of the document. These additional model estimation yield equivalent overall conclusions on the subject of the importance
of particular model inputs and assumptions, relative to those based on the (presented) model estimations, where the modified
default value model is applied. This fact obviously enhances the robustness of the conclusions highlighted in this study.
84
forward (re)valuation of all the positions in the portfolios. Moreover, the credit migration matrices and all
correlations would have to be re-estimated based on the new estimation dates. Furthermore, the idea behind
the procedure may sound very appealing in a validation context, but the selection of the relevant migration
and default risk benchmarks may be much more difficult than one would expect at first sight. Useful or
functional benchmarks of this kind may not even exist. Again, extensions of this kind to the model
estimations in section 3.1 can be seen as suggestions for improvement. The initial objective was to present a
general picture of the workings of the model and identify its most critical components. In that context, the
model estimations and their evaluations have already presented a vast amount of useful information.
The last aspect, concerning the scope of the exercise, is an extension to also incorporate non-US issuers. Such
an extension does not really shed more light in the workings of the model, but it is an extension that is likely
to be required in an actual incremental risk model. In essence, trading portfolios nearly always contain assets
from multiple countries. Nonetheless, such an extension is very straightforward. The effects within the model
are almost certainly equivalent to those observed in the model estimation in section 3.1, as the model
dynamics do not actually change. Basically, the only difference is that a set of additional inputs is required
when, for example, UK issuers are also included. First of all, a separate UK credit migration matrix is needed,
as migration probabilities tend to differ across countries and regions. In addition, UK credit yield curves are
also required, as yields tend to differ substantially across countries and regions as well. Essentially, the value of
a bond of a US BBB-rated issuer can be substantially different from that of a similar bond of a similar UK
BBB-rated issuer. Note, however, that these yield curves should be based on the currency of the country in
which the bank that is holding the trading portfolio is located. Lastly, additional important inputs like recovery
rates are best specified conditional to the UK as well. Thus, it is best to condition all inputs to the specific
countries of the issuers that are assessed with the model. For small countries, however, the necessary credit
migration data and credit yield curves for low ratings (B and CCC/C) are not likely to be available. In such
cases, one has to settle with more general data (European data for Dutch issuers for example).
The last point of attention here is the estimation of issuer correlations when multiple countries and therefore
multiple currencies are assessed. In essence, one should use equity return data that is based on the local
currency of each respective issuer. Why not use US dollar return data when the bank holding the portfolio is
located in the US? The answer is quite simple. When US dollar equity returns are used for a UK issuer for
example, then if the UK issuer generates a large negative return in British pounds but the pound appreciates at
the same time, then US dollar return may indicate only a slight deterioration in creditworthiness of the issuer,
while in fact the issuer may be close to default as a result of the poor actual British pound return. Hence, the
British pound return is more relevant for the actual credit quality of that issuer. Basically, the own local
currency return provides a more clean assessment of the issuers credit quality. In fact, a conversion to another
currency is only more likely to introduce noise in this assessment. Since the point of interest is the correlation
between issuers in their actual level of credit quality, it is obvious that local currency returns are required.
3.2.3 Stand-Alone Risk
The primary aspect of the stand-alone risk specification obviously is the credit migration matrix. One general
issue underlying the credit migration matrix is that it might approach migration and default risk in a too
general form. In the utilization of a single migration matrix, all BBB-rated issuers for example are assumed to
be subject to identical migration probabilities. In reality, this assumption is likely to be flawed. Conditional
credit migration matrices may provide a solution to this issue. As pointed out in the credit migration matrix
estimation section (Part II section 2.1.6), credit migration dynamics can be approached in a much more
detailed setting. The most important additional characteristics that may be incorporated in the simulation
model through an extended credit migration matrix specification are: rating drift, business cycle effects, effects
of macroeconomic factors and industry specific credit migration dynamics.
The utilization of different migration matrices conditioned to different industries is a very simple way to
enforce a more detailed risk specification. A stand-alone migration and default risk specification of this kind
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may sound appealing, as it would be consistent with the fact that the required credit yield curves are also often
available for each industry in the valuation context. The disadvantage of this extension, however, is the limited
availability of underlying data per industry, which will result in a very limited reliability of the migration
probability estimates resulting from these rather small datasets. Moreover, conditioning on industries is never
in the literature addressed as the most essential additional estimation specification in the credit migration
matrix.
In essence, rating drift is regarded in the literature as the most important (non-Markov) effect that is not
captured in a straightforward migration matrix. The incorporation of rating drift in the credit migration matrix
specification requires a much more complicated approach. Even though rating drift is introduced in the
simulation model through the asset return autocorrelations, incorporating it directly into the stand-alone risk
specification should allow for a much more accurate display of the observed credit migration dynamics.
Nevertheless, such an extension to the proposed simulation model requires complicated credit migration
matrix estimation techniques such as Markov mixture models as in Frydman (2005) and Frydman &
Schuermann (2008) or multiple hidden Markov chains as in Christensen et al. (2004). The estimation of these
models may not be a real issue, but the estimation output has to be modelled into the simulation structure as
well. The construction of a simulation structure that incorporates rating drift, as it is observed in historical
credit rating datasets, will however make the simulation substantially more realistic. Its effect on the models
required risk measures is likely to be similar to that of the incorporation of autocorrelations.
Another approach to the incorporation of rating drift and also macroeconomic covariates is the application of
hazard functions that directly assess the intensities on which the duration migration matrix estimation
methodology is built. Such a methodology is applied by Lando & Skdeberg (2002) to assess rating drift. In
addition, Figlewski et al. (2008) employ it to approach the effect of macroeconomic factors as well. Hazard
models of this kind may even be altered to incorporate firm-specific financial statement data, as is often
performed in default prediction hazard models (e.g. Whalen, 1991; Shumway, 2001; Chava & Jarrow, 2004).
Again, the incorporation of such highly specified assessments of credit migration dynamics in the model
definitely will significantly enhance to the quality of the simulation model.
The conditioning of the credit migration matrix to stages of the business cycle is often applied in the literature
as well. In fact, the credit crisis migration matrix that is estimated in Part II section 2.1.6 can be regarded as a
conditional migration matrix of this kind. In essence, it is nothing more than selecting an estimation sample
that applies to a specific economic environment. The Basel II Framework does not contain requirements to
incorporate rating drift or macroeconomic factors in the use of a credit migration matrix specification. It does,
however, provide some guidance with respect to conditioning in the form of the estimation sample period on
which risk specification can be built (BCBS, 2006). Two important aspects are relevant in this context. The
first is regulatory capital arbitrage and the second is the general intuition of the whole incremental risk model,
which is to some extent again related to the capital arbitrage aspect.
As stated in the introduction, regulatory capital arbitrage between the trading book and the banking book is
one of the main reasons for the introduction of the Incremental Risk Capital Charge. The incremental risk
model (IRC-model) should provide the level of capital requirements for the positions in the trading book and
in most cases the internal ratings-based model (IRB-model) should produce the level of capital requirements
for the positions in the banking book. In both models the 99.9% value-at-risk measure is applied. Then
obviously capital arbitrage between both books is prevented when both models deliver the same charge for
similar positions. The Basel Committees incremental risk model guidelines even contain a proposal of the
application of the banking book treatment to the trading book or to apply it for the most illiquid positions.
Nonetheless, all financial institutions that commented on this proposal strongly disagreed with such a
treatment. The primary reason was that banking book and trading book positions are subject to different risks,
as the key risk driver in the banking book is the probability of default and in the trading book more general
(market related) forces play a much larger role. Moreover, the treatment would not be consistent with risk
management objectives and practices.
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What does capital arbitrage between the trading book and banking book has to do with the conditionality of
the credit migration matrix? Essentially, if both books must be subject to similar capital charges then their
general specification in terms of conditionality should also be relatively similar. The incremental risk model
guidelines do not contain any requirements regarding the conditionality, in the form of the estimation sample
period, on which the (stand-alone) risk specifications should be built. Even so, the internal ratings-based
approach roughly offers two choices in the sample period conditionality of probabilities of default and other
related utilized risk components. The first is a through-the-cycle specification and the second is a point-intime specification. The through-the-cycle specification basically implies that one or more (business) cycles
should be taken into account, where one cycle is believed to last between ten and twelve years. The point-intime specification is approximately equal to conditioning to the current economic environment. The point
here is that when one of the two is applied in the internal ratings-based model, the incremental risk model
should be based on the same specification to achieve the required consistency.
On the other hand, when the intuition and objectives behind both models and the practical nature of the
positions that they assess are taken into account, the opposite conclusion may be reached. The internal
ratings-based approach assesses the banking book which contains long-term illiquid positions, whereas the
incremental risk model addresses the trading book which predominantly contains positions that are held for
sale or trading.68 Thus, in the trading book the short-term environment is much more relevant, as positions
that are held for trading purposes obviously require an assessment of their value and risk in the current market
environment. Conversely, in the banking book the current market environment is of much less importance, as
positions are mainly held to maturity. In the banking book, results generally materialize in the long-term.
Hence, the long-term environment is more appropriate here. Furthermore, a through-the-cycle specification is
better aligned with such a long-term objective, whereas the short-term is more consistent with a point-in-time
specification. In other words, both models intuitively require different conditionality specifications, while
these conditionality specifications should be roughly similar to prevent capital arbitrage. Note, however, that
similar capital charges can also be generated with different conditionality specifications in both models, albeit
certainly much more difficult to achieve. In such a setting, both model are inconsistently defined and therefore
behave fundamentally different. The principal objective of the incremental risk model, however, must not be
forgotten. The model should address the default and migration risk incremental to the credit positions in the
trading book. It is not just introduced to prevent capital arbitrage.
In addition, emphasis must also be placed on the general statistical intuition of the actual risk measure that is
required in the incremental risk model. As mentioned, at first sight the short-term current environment
approach of a point-in-time specification seems more appealing for trading positions. Nonetheless, if the
nature of the required value-at-risk measure is taken into account, another conclusion might be reached. For
example, consider the migration matrix conditional to the credit crisis. This matrix can be seen as a point-intime specification of the migration matrix. Then when the 99.9% one-year VaR is taken from the portfolio
return distribution, it implies that the 99.9% worst result in the credit crisis market environment is taken,
which is a scenario that would only occur once in 1000 years of credit crisis. Basically, an extremely poor
scenario is assessed, within a market environment that can be classified as an extremely poor scenario on itself.
The credit crisis on itself can be defined as a 90% to 95% worst scenario at best. Based on S&P500 annual
returns it may even be close to the 99% worst scenario.69 In this context, it would be utter nonsense to apply a
point-in-time specification for the credit migration matrix, as it ensures a scenario that would never occur is
approached. Although such reasoning is inherent to the credit crisis being the current market situation, the
point is remarkably clear.
The counterargument here is that for such reasoning to be entirely valid, one must assume that an incremental
risk model perfectly assesses the 99.9% one-year VaR. In reality, this is obviously far from the truth. For a
68
69
Through the years, trading books have become much less liquid than initially anticipated. Hence, it would not be prudent to argue
that the trading book mainly contains highly liquid positions.
In more than 80 years of annual S&P500 returns, only the 1931 return was worse than the 2008 return.
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perfect assessment of the loss distribution, the behaviour of most relevant variables is much too unstable. In
statistical terms, a model assumes that whatever is modelled is a repetition of the same experiment to which
the underlying data is subject to. Nevertheless, its critical components lack the stationarity that is required to
make such an assumption. Consequently, a perfect or nearly perfect assessment the loss distribution is
impossible, especially that far in the left tail of the portfolio value distribution.70 The point-in-time
specification may consequently be the better specification in practice, since it provides higher model implied
risk measures in times of economic turbulence. Such a specification is highly risk sensitive, as the models risk
measures increase during economics turmoil, since its inputs are conditional to that economic turmoil. These
higher value-at-risk measures provide an extra safety buffer in times when the 99.9% one-year VaR from a
model, that is built on a through-the-cycle specification, is more likely to be breached.
A disadvantage is that the extra safety buffer only appears a substantial period after an economic downturn is
initiated, since the economic turbulence must have entered the applied dataset. Thus, the level of regulatory
capital requirements is always lagged to the business cycle, which will result in too low capital requirements at
the start of an economic downturn. More important, however, is that the point-in-time specification amplifies
the pro-cyclicality in the Basel II capital regime. A pro-cyclical capital regime promotes business responses
that exacerbate the strength of the economic cycle.71 Thus, when capital requirements fall in benign periods,
this can accentuate the boom with well-capitalized banks able to expand lending aggressively. On the other
hand, if capital requirements increase in recessions, banks facing capital constraints may reduce lending which
will worsen and may even extend the recession (FSA, 2009). The pro-cyclical nature of the current Basel II
capital regime is exactly what has previously been addressed as one of the major issues surrounding the Basel
II Framework. Hence, increasing its magnitude would be a significant step backwards.
To address the issue of pro-cyclicality, the more stable through-the-cycle specification would be the obvious
choice, as recommended in FSA (2009).72 The more long-term through-to-cycle specification should be more
or less unaffected by the economic circumstances and is therefore non-cyclical. A higher Incremental Risk
Capital Charge is then only initiated by more risky investments, which is still in line with the original Basel
Framework risk sensitivity intuition. The through-the-cycle specification, however, is subject to other
conceptual modelling and validation issues. For example, the magnitude or effects of assessed risk factors can
vary across different economic cycles, as downgrade and default rates were much higher in the credit crisis
cycle than in the IT-bubble cycle. Hence, data from multiple cycles is required and, as a cycle is believed to
cover a horizon of roughly ten years, an exceptionally long sample period is needed. Then if data of this
nature are in fact available, one could still question the relevance of data of such a long period ago in todays
modelling of the future. More issues of the through-the-cycle specification are addressed in Rowe (2003).73
In summary, there is no obvious correct answer in the conditionality choice combined with the capital
arbitrage issue. This is also the main reason why there is not yet any consensus on the subject at this point in
time and why currently there is an IRC/IRB debate between the banking industry, regulators and validators on
the required consistency between the charges provided by both models. The only real contribution of this
study to that debate is that the model estimations in section 3.1 show that through-the-cycle and point-in-time
specifications of the credit migration matrix can generate very substantial differences. The unconditional credit
70
71
72
73
The required and modelled one-year 99.9% worst result may even be classified as Knightian uncertain (Knight, 1921), since
scenarios of such an extreme nature are in fact not directly assessable with historical data. Hence, the modelling of these scenarios
will largely depend on the assumed distributions of the key (risk) factors in the model (e.g. the copula assumption in the proposed
incremental risk model).
Parsons (2009) states that the Quantitative Impact Studies, that were completed whilst the Basel II Framework was being
developed, indicate that the capital required to support the same portfolio increases roughly 25% percent from the top to the
bottom of the cycle when losses are excluded. In case the capital effects of losses are included the increase in regulatory capital
requirements even is approximately 40% (mainly based on BCBS, 2003).
The Financial Services Authority even proposes counter-cyclical capital buffers (FSA, 2009).
Rowe (2003) argues that, while the through-the-cycle specification might partially mitigate the pro-cyclicality in the Basel II capital
regime, it would also introduce unacceptable vagueness into the estimates and seriously undermine the basis for backtesting and
validation.
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migration matrices can be seen as through-the-cycle specifications, since they all address roughly two business
cycles within the 20 year sample period, whereas the conditional credit migration matrix can be seen as a
point-in-time specification, as it only considers the current environment. The differences generated between
both types of specifications for all three estimated value-at-risk measures are very large and robust to the
entire variety of additional model specifications applied in the model estimations.
Apart from the credit migration matrix, the recovery rate can be defined as part of the stand-alone risk
specification as well. This subject has received relatively little attention in the model derivation and estimation
assessment. Yet it has been identified as an input that will generate large impact on the 99.9% VaR-estimates if
it were to be changed. In the construction of proposed model, the only real step that has been taken to create
realistic recovery values in the model is that the recovery rate has been made stochastic. In addition, the
standard default value was modified to deal with the much too high historical average S&P recovery rate for
current market conditions. Nonetheless, as previously stated, this modification should not be enforced when
reliable expected recovery rate estimates are available.
Furthermore, even though the stochastic nature of recovery in the model substantially enhances the validity of
the model, further improvements are possible and may even be required since the recovery rate has a great
effect on the required VaR-measure. A detailed recovery rate specification in an actual incremental risk model
will definitely increase its quality. As set forth in Part I section 1.3.3, the model estimations utilize a single
recovery rate distribution for all positions. Nonetheless, Standard & Poors Default, Transition, and Recovery:
2007 Annual Global Corporate Default Study and Rating Transitions (Premium) contains more specific recovery rates
and corresponding standard deviations. They are given for each seniority level, multiple product types and for
each industry. Hence, a simple model improvement would be to apply a recovery rate for each position that
corresponds to the industry and the product type of that position, given that these recovery rates can be
expected to be reliable in relevant market environment.
Note that the conditionality issue discussed above becomes relevant in this context as well, since the recovery
rate may be conditioned to stages of the business cycle as well. In fact, as mentioned in the model
construction, Vazza et al. (2008) as well as Emery et al. (2009) argue that there is a (inverse) relation between
average default rates and recovery rates. Basically, in every Moodys or S&P recovery rate publication since
Hamilton et al. (2001) this relation has been addressed. Obvious, it has been documented in the literature as
well (e.g. Schleifer & Vishny, 1992; Freye, 2000b, 2000c; Altman, 2001). The basic theory is that economic
conditions that cause the number of defaults to rise also negatively affect recovery values (Altman et al.,
2003).74 Theories or empirical relations of this kind can be implemented in the proposed simulation
framework.75 Jarrow (2001) and Frye (2000a, 2000b) may provide useful assessments on this subject. The
incorporation of strong empirical relations obviously contributes substantially to the required descriptive
qualities of the proposed simulation model. Herein, one must keep in mind, however, that high recovery rate
inputs, or the possibility of high recovery rates through the incorporation of such an empirical relation, can
result in highly unrealistic expected default value scenarios such as the Cintas Corp bond example that was
presented in Part I section 1.3.3.
74
75
Note that the inverse relation between the average recovery rate and the average probability of default (the stage of the business
cycle) also motivates the use of the modified default value model in the model estimations in section 3.1. The VaR-measures are
taken from extremely poor scenarios which essentially correspond to the bottom of the cycle. Consequently, the historical average
recovery will definitely be much too high in these scenarios, which in its turn is highly likely to induce a risk underestimation in the
model (i.e. too low 99.9% VaR estimates).
One may even impose a relation between credit spreads or credit yield curves and average default rates (the stage of the business
cycle) in the simulation model, since it is more or less common knowledge that credit spreads increase during episodes of economic
turmoil (the bottom of the cycle in the simulation model context). Similar to the recovery rate for defaults, the credit yield curves
determine the value change of the position in case of a downgrade or upgrade. In essence, it might be most valid to reconstruct the
relations between all inputs that reinforce the business (or credit) cycle in the simulation model, as in such a structure the poor
simulation scenarios, from which the VaR-estimates are taken, are defined more accurately, given the applied description is
adequate. Again, the point-in-time vs. through-the-cycle model specification issue plays a crucial role in the decision to incorporate
relations of this kind.
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3.2.4 Correlations
First of all, it is worth emphasizing again that the nature of the correlations, the copula assumption, in
combination with the average level of issuer correlation, is the most important correlation specification in the
proposed model and almost certainly in the incremental risk model in general as well. The proposed model
can basically handle copula assumptions and corresponding correlation structures of any kind. The only two
requirements are that the copula can be applied to simulate correlated drawings from the relevant distribution
according to a pre-specified correlation matrix and that this distribution can be used to compute the asset
return thresholds (Z-values) that are required in the simulation model. If these requirements apply, the
complete simulation model as proposed in Part I section 1.3 can be utilized.
The next relevant subject in the correlation context obviously is the actual correlation matrix. First, however,
it is important to note that the estimation period or business cycle conditionality issue, that was discussed in
detail in the previous section, also applies in the correlation risk context. The difference is that the risk
measures of the incremental risk model in general are likely to be less sensitive to the estimation period
conditionality of the issuer correlation estimates. Moreover, the Basel II Framework and even the incremental
risk model guidelines define a much clearer preference regarding the period to which the issuer correlations
should be conditioned. That is, the current market environment is the generally accepted conditionality
specification. One must, however, be cautious in the application of conditionality through issuer correlations,
since the model estimations demonstrate that increased (credit crisis) issuer correlations do no fully
reconstruct the downgrade and default cluster that was observed during the credit crisis. A linear issuer asset
correlation structure almost certainly is too simple to capture actual credit quality relations between issuers,
especially during episodes of economic turmoil.
The next correlation topic is the actual issuer correlation coefficients that are required in the model. Based on
the model estimations and as mentioned in section 3.2.1, the precision of the individual issuer correlation
coefficients are likely to be of less importance than initially anticipated. Obviously, this does not imply that the
issuer correlations are of no value in the model. It is still of vital importance that the model accurately displays
the average correlations level or more specified average issuer correlation levels. As mentioned, the short
positions in an actual trading portfolio will in most cases provide a risk reducing effect in a high correlation
environment. Yet, the magnitude of this effect is highly dependent on additional model parameters such as the
applied recovery rate(s) and the credit yield curves. This aspect ensures that the net effect of a correlation
increase cannot be entirely known in advance.
In a statistical context, such a correlation increase can be seen as trend break. Once more, the stationarity
assumption underlying most models and also the proposed incremental risk model becomes relevant here. It is
assumed that the future, which is being modelled, is a repetition of the same experiment as that to which the
underlying data is referring. An unanticipated trend break in issuer correlations severely violates this
assumption, since it ensures that the historical data, on which the correlations are based, suddenly is to a large
extent not relevant anymore. Hence, when issuer correlations are modelled in a point-in-time spirit, which is
essentially required by the incremental risk model guidelines, then an unanticipated trend break in actual issuer
correlations will impose a large problem in the model. This possibility of a misspecification of issuer
correlations, in case of a trend break in actual issuer correlations, produces yet another case for the use of
equity based correlations in favour of asset correlations based on default rates. Equity based correlations are
generally higher than asset correlations based on default rates, and will therefore be more conservative, which
ensures that a potential trend break may generate less severe effects in the model when equity based
correlations are utilized. Moreover, as explained in the description of the methodology in Part II section 2.2.2,
the too general nature of default rate based asset correlation estimates produces in a downward bias in the
average issuer correlation level. Basically, default data is too scarce to apply the methodology to issuer groups
that are homogeneous enough to generate reliable implied asset correlation estimates or a reliable average
issuer correlation level. Thus, the practical usefulness of the correlations based on default rates seems rather
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limited in the incremental risk model context. In theory, the methodology may be especially appealing, yet the
default data issues are much too severe to generate correlation coefficient estimates on a detailed level.
Equity based issuer correlations appear to be the best alternative in the calibration of credit quality
correlations in the proposed incremental risk model. And since the precision of the individual issuer
correlation estimates is not likely to be of vital importance for the accuracy of the model, the difficulties in the
estimation of the correlation coefficients, as addressed in Part II section 2.2.1, suddenly are much less severe
than previously anticipated. In the estimation of equity correlations, the frequency problem has lost much of
its relevance, as the average correlation level is very similar for different frequencies. For instance, the mean of
the average equity correlation level in the stable period is 0.21 with a maximum of 0.23 and a minimum of
0.19 over the different frequencies.76 In addition, for the credit crisis period, the mean of the average
correlation level over the different frequencies is 0.45, with a maximum of 0.49 and a minimum of 0.44.
Consequently, any of the assessed frequencies will yield approximately equal VaR-estimates in the model. The
frequency selection should therefore mainly be driven by the number of observations that it will generate. The
utilization of weekly or even daily returns seems to be the best choice, since both frequencies still allow for a
relatively short sample period that displays the current economic environment to a reasonable extent.
Subsequently, one may use a multiple factor model in the actual correlation estimation process, like those
evaluated in Zeng & Zhang (2001), since these models provide an easier estimation procedure when the
number of issuers is large. Moreover, the issuer correlation estimates resulting from an advanced multiple
factor models are also likely to be more accurate, relative to regular historical correlations. Conversely, when
enough equity data is available, simple regular historical correlations may provide correlation estimates with
enough precision as well (Zeng & Zhang, 2001). Herein, the use KMV model based asset returns (as described
in Bohn & Crosbie, 2003) instead of plain equity returns will enhance the accuracy of the credit quality
correlations in both types of correlation estimation procedures (Zeng & Zhang, 2002).
Lastly, as mentioned before, additional attention would be prudent for concentrated positions and market
concentrations in the estimation of issuer correlations. The effect of the existence of these concentrations can
be substantial, as demonstrated in section 3.1.4. Consequently, in particular the correlations underlying market
concentrations must be approached accurately in the estimation process, since the recognition of market
concentrations primarily depends on the correlations between their underlying issuers. Inaccurately calibrated
correlations between these underlying issuers may bias the models VaR-estimates, especially when the
concentrations are relatively large and are comprised of only long or only short positions.
In the estimation of the issuer autocorrelations, basically the same arguments apply as in the issuer correlation
case. The calibration of autocorrelations may be best approached by equity autocorrelations with a similar lag
as the length of one period in the model. The effect of autocorrelation is almost certainly quite small, as long
as the average input autocorrelations are also small on average, which is a very likely possibility in reality.
An alternative view on the incorporation of autocorrelation in a multi-period model is offered by Dunn
(2008), who models autocorrelation into his incremental default risk model with the use of an autoregressive
risk factor. Such a structure is likely to raise the models risk measures, since all issuers in the model will be
subject to positive autocorrelation.77 Recall that positive autocorrelation in the model increases the implied
risk, since it enlarges the chance for a low simulated issuer asset return and therefore possible downgrade or
default in a period, when the simulated issuer asset returns in the previous period was low already. In
summary, it makes poor scenarios worse, which increases any VaR-estimate. Hence, it might be conservative
to implement such a structure. Nevertheless, no positive equity or asset autocorrelation is observed for many
issuers, making such a correlation structure at least partially unrealistic. Dunn (2008) does, however, point out
76
77
Recall that the utilized return frequencies were: daily, weekly, two weeks, three weeks and monthly.
Even issuers of which the asset returns are assumed to be negatively correlated to the autoregressive risk factor still display positive
autocorrelation. In the model proposed by Dunn (2008), negative autocorrelation can only exist when the sign of the correlation
between the autoregressive risk factor and the issuer returns changes the next period. Such a structure, however, is very unrealistic.
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that more complicated factor model based autocorrelation structures are possible that display autoregressive as
well as mean reversion characteristics. Assuming that such structures can be modelled to display observed
effects with a very reasonable accuracy, they may provide an excellent alternative option in the correlation
structure of an actual incremental risk model.
Another difference between the autocorrelation application in this study and Dunn (2008) is autocorrelation at
rebalancing moments. A small increase in the model implied risk, relative to the results presented in this study,
can be expected when autocorrelation is introduced at rebalancing moments, as applied by Dunn (2008). This
is, however, in contrast with the model specification proposed in this study, as discussed in Part I section
1.4.6, since it is to a certain extent not in line with the constant risk assumption. Nonetheless, such a model
specification can be implemented in the proposed incremental risk model or an actual incremental risk model.
Lastly, it is extremely important to note that when rating drift is incorporated in the stand-alone risk
specification, autocorrelation in the correlation structure of an incremental risk model basically addresses the
same effect for the second time. The essence of incorporating autocorrelation is to take into account the
observed market inefficiency in the time-series dimension. Nevertheless, this effect is addressed much more
accurately in the stand-alone risk specification, since it is directly estimated and modelled to resemble
observed credit migration dynamics. In principle, those dynamics are the risk source that the incremental risk
model is required to capture. When the effects are addressed in the correlation structure, by introducing equity
autocorrelations for example, then rating drift is modelled in a more indirect and probably inaccurate way.
Hence, the most efficient approach in capturing rating drift is through the stand-alone risk component in the
model, the credit migration matrix, applying techniques as proposed in Christensen et al. (2004) or Frydman &
Schuermann (2008) for example. In that case, autocorrelation must not be incorporated in the correlation
structure, which in its turn drastically simplifies the derivation of this structure. Moreover, all aforementioned
issues related the estimation of autocorrelation coefficients become irrelevant in such a setting.
3.2.5 Constant Level of Risk Assumption
The constant level of risk assumption in combination with the liquidity horizons have been the most
challenging elements in the construction of the proposed incremental risk model. The constant level of risk
assumption is not so much an input or assumption that has to be estimated or calibrated, such as the credit
migration matrix or the copula assumption, yet it is a crucial component in the estimation of the ultimate risk
measures of the incremental risk model in general. In addition, the constant risk assumption and the liquidity
horizon are among the few mandatory elements in the model. Finger (2009) acknowledges that the constant
level of risk assumption unquestionably is the most controversial element of the Basel Committees
incremental risk model proposals. Apart from the fact that the emphasis the Basel Committee has placed on
the subject of liquidity is a remarkably valuable objective on itself, its implementation in the form of the
constant risk assumption is surrounded by practical as well as theoretical ambiguity. Moreover, in practice the
assumption may be unrealistic for most trading portfolios.
Finger (2009) argues that the constant level of risk modelling requirements are an invitation to arbitrary
recipes, and may lead to the manipulation of the minimum required capital through superfluous complexity.
This notion is at least partially confirmed by the required complexity and theoretical inconsistency
encountered in the derivation of the double copula based correlation structure of the proposed model (Part I
section 1.4). Basically, the implied issuer correlation must be calibrated to equal the observed issuer asset
correlations. However, in the presence of autocorrelation, the implied correlations between the underlying
issuers cannot be equal to the issuer correlations in the single-periods of the multi-period model.78 Hence, the
78
Note that definitions of implied correlations different from the one applied in this study are a possibility as well, since the Basel
Committees Incremental Risk Capital Charge guidelines do not contain any guidance on this subject. Vagueness in concepts that
are imperative to any incremental risk model, such as the implied correlations, is likely to contribute to arbitrary recipes and
complexity in actual incremental risk models.
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single-period issuer correlations in the cross-sectional dimension of the correlation structure may be not in
line with observed correlations. Moreover, multiple (hypothetical) issuers may contribute to an implied
correlation of a single position, which does not make much sense theoretically.
In addition, a number of logical contradictions that may result from the constant level of risk assumption are
highlighted by Zerbes & De Prisco (2009) in Algorithmics comments on the Basel Committees most recent
proposal. An awkward contradiction arises from the principles of utility theory. Herein, the assumption of a
constant level of risk implies that when a bank experiences losses, it will fund the losses from capital,
essentially reinvesting an amount equal to the initial value of the respective position into a very similar or
identical investment. At the same time, this new investment accounts for a larger share of the banks wealth,
since the banks has incurred losses. Consequently, such a bank is willing to take relatively more risk for the
same reward. In essence, this means that the assumption of a constant level of risk implies a decreasing
marginal utility of wealth (at least to some extent). This implication naturally contradicts the most common
axioms underlying utility theory.
Zerbes & De Prisco (2009) also state that during the crisis banks have not shown a tendency to reinvest at
previous risk levels. In contrast, capital preservation and de-leveraging have been at the very top of the agenda
at most banks. Areas that suffered significant losses have been only subject to reinvestment at a level
constituting only a fraction of the initial investment. The observed behaviour of banks implies that the
constant risk assumption is only realistic under normal market conditions and that it fails in the context of
extreme markets. Nevertheless, the capital charge is measured in extreme market conditions (the 99.9% worst
loss). In essence, in the context of the proposed incremental risk model, the left tail from which the required
VaR-measure is taken, is the part of the loss distribution in which the constant risk assumption is not likely to
be valid. Furthermore, in accordance with Finger (2009), Zerbes & De Prisco (2009) also argue that the
constant risk structure may be a source of unneeded complexity.
Another point of critique on the assumption is again provided by Finger (2009). He argues that the constant
level of risk assumption in fact does not imply constant risk, in an extreme market environment. The point is
that when a position is rebalanced in a rising credit spread environment, the new position does not hold the
same amount of risk as the initial exposure, since the increased spread of relevant credit rating implies that the
risk of credit migration or non-payment has in fact increased. This point is confirmed by the enlarged
downward potential in the credit crisis migration matrix relative to the one based on 20 years of migration
data. Hence, when economic circumstances deteriorate, a position with similar correlation properties and an
equal credit rating cannot be seen as a position with a risk profile equal to the initial exposure. The timevarying nature of migration and default risk renders the claim on constant risk improbable. This argument
goes hand in hand with the previous argument, as both cast doubts on the validity of the constant level of risk
assumption in the an extreme market environment. Again, the importance of both arguments is seriously
amplified by the fact that the required one-year 99.9% VaR measure is generated by a scenario of such an
extreme nature.
In comments on the incremental risk model guidelines, many other banks state that the constant level of risk
assumption is not in line with actual banking and risk management practices. Nonetheless, the constant level
of risk structure may be the only viable way to incorporate multiple liquidity horizons in one general uniform
capital horizon. The uniform capital horizon is a (statistical) requirement when the ultimate capital charge
must be based on a value-at-risk measure. Consequently, the abovementioned complications may be inherent
to the structure and soundness standard that are favoured by the Basel Committee. Any implementation of
different liquidity horizons for different positions within one uniform capital horizon will experience
difficulties of this kind. In summary, the theoretical as well as practical ambiguity of the constant level of risk
assumption may be a sacrifice the Basel Committee is willing to make in order to amplify the effects of
liquidity in a value-at-risk based capital charge. In fact, it is highly unlikely that the constant level of risk
structure, as set forth in the current proposal of incremental risk model guidelines, will be changed before the
finalization of these guidelines.
93
3.2.6 Additional Valuation Assumptions

The valuation procedure in the simulation model dependents on a number of assumptions as well. The most
imperative of these assumptions obviously is the forward valuation assumption. The forward valuation
procedure, as proposed in the CreditMetrics model, relies on the predictive power of the forward rates.
However, the forward interest rate in general only has to be in accordance with a no arbitrage condition, to
connect interest rates of different maturities. In addition, theory implies that it should, at least to some extent,
display the market expectation of the interest rate in between those maturities as well. Although it has often
been demonstrated that the forward rate contains information about that upcoming interest rate, it is by no
means believed to be a perfect predictor. Term premia and liquidity premia, which are part of the forward rate
as well, are the main reasons for the limited forecasting power.
In case of the forward credit yield curve, generally the same applies. Although the no arbitrage condition does
not actually apply anymore, as yields are artificial constructs (i.e. one does not directly receive the yield in bond
investment), term premium effects and especially liquidity effects are extremely likely to be present in credit
markets and corresponding credit yield curves. Consequently, forward credit yields may not perform well as
predictors of the credit yields of the subsequent period or later periods. Especially in periods of financial
turmoil, liquidity and term effects can become substantial. The recent credit crisis is an excellent example of a
demonstration of the large liquidity effects in credit markets. Hence, the forecasting power of the forward
credit curves during times of financial turbulence, and to some extent in general as well, is one of the major
weaknesses in the CreditMetrics model and consequently also in the proposed incremental risk model.
Another troubling aspect that emerges here is that liquidity is accounted for twice in the model. It is handled
explicitly through the constant risk assumption and the incorporated liquidity horizons, but is it also implicitly
handled in the utilization of the credit yield curves. One might argue that a solution to this complication is to
attempt to circumvent the use of credit yield curves. Nevertheless, credit curves form an integral part of the
valuation process in the model, but also in general in the pricing of credit products. Circumventing their use
may not be impossible, but it certainly will result in numerous additional issues. It may be easier and more
valid to attempt to correct for the liquidity effect in the credit yield curves.
A second point of attention in the credit yield forward valuation process is the type of credit yield curves that
are applied. In the model estimations, one credit yield curve is employed for each credit rating for all positions
(see appendix A.4). The unrealistic assumption that all positions can be valued with equivalent credit yield
curves is implicitly made here. An obvious improvement to this procedure is to employ different curves per
credit rating for each industry to generate a more specified valuation of the different positions in the portfolio.
Nevertheless, difficulties emerge in this approach since many industries have a limited number of curves
available on Bloomberg Professional or Thomson Datastream. In essence, for each industry, the curves
corresponding to all seven credit ratings are required, which makes this more detailed approach probably not
feasible for research of this kind. Banks, however, do have much more specific and detailed information
privately available. Therefore, most banks will almost certainly use a more detailed credit yield curves/spreads
specification in their incremental risk model, which will deliver a substantial model improvement.
A third point of attention in the valuation model is the forward rate accrual assumption. In summary, this
assumption specifies the accrual rate at which losses or gains that occur before the end of the capital horizon
should be pushed into the future to the end of the capital horizon. As already stated in the valuation
description in Part I section 1.3.2, there are three potential candidates: (1) the relevant forward credit yield of
the initial credit rating of the position, (2) the relevant forward risk free rate (see Part I section 1.3.2, footnote
15) and (3) a value-weighted average of the relevant forward credit yields.79 The first of the three is applied in
the model estimations (the motivation underlying this decision is given in the valuation description).
79
Recall that this value-weighted average of forward credit yields is an average of the forward credit yields of the credit ratings that are
present in the assessed portfolio, which are weighted according to the relative exposure to each credit rating in the portfolio.
94
One must realize, however, that when this assumption is changed the model estimation results change as well.
The application of the (value-weighted) average forward credit yield, for example, implies that for each gain or
loss an equal accrual rate is applied, independent of the credit rating of the position. Such a valuation
assumption may be appealing a portfolio context, but its use will result in less conservative model implied risk
estimates. Basically, the application of the forward yield of the initial credit rating of the position indicates that
higher accrual rates are employed for the lower rated positions, which are most likely to default or to generate
losses (these positions are subject to higher downgrade probabilities in the credit migration matrix). In this
setting, the losses of lower rated positions before the end of the capital horizon are enlarged with a relatively
high rate in the portfolio valuation at the end of the capital horizon, as a result of to their low initial credit
rating. Consequently, the positions that are most likely to generate losses receive the most conservative
forward accrual valuation treatment.
In the comparison of the average forward credit yield accrual assumption relative to the use of the forward
credit yields of initial credit rating, it is evident that the use of the average forward credit yield will result in
lower simulated losses at the end of the capital horizon, since it implies that an identical forward accrual
treatment is used for each position, even though lower rated positions may generate more losses. This applies
even more to the possible application of the forward risk free rate, as in such a setting possible losses that
occur before the end of the capital horizon all accrue at the lowest possible rate, yielding the least conservative
risk estimates of the three accrual rate assumptions. Notice that the effect of changing this assumption in the
model estimations is likely to result in a relatively smaller decrease in the models risk measures in the longshort portfolio, since again the effects are partially cancelled out by the short positions in the portfolio.
Furthermore, the issue discussed here applies in general in the development of an incremental risk model.
Rebalancing will occur in an actual incremental risk model therefore a forward accrual rate must be specified.
As pointed out, the selection of this forward accrual rate is less straightforward is it looks at first sight. Also
note that changing the forward accrual rate assumption is not likely to distort any of the interpretations and
conclusions drawn in Part III, since all model estimations will be affected in very similar ways. Hence, the
relative differences between the presented VaR-estimates will remain approximately equal, while it are these
relative differences that constitute the basis underlying the interpretations and conclusions.80
One final valuation assumption or complication in the proposed model deserves some attention in this
assessment. This complication concerns the possibility of default and rebalancing before the end of a singleperiod. Notice that in a four-period model a single position can default four times, while in a twelve-period
model, for example, a single position can default twelve times. This apparent inconsistency is largely cancelled
out by the obvious fact that the default probability of a given rating class for a single-period in twelve-period
model is much lower than the default probability of the same rating class in a single-period in a four-period
model. The real complication generated by these two aspects is that a default probability in the multi-period
model also captures the possibility of default before the end of a single-period. Nevertheless, in the simulation
model the loss always materializes at the end of the single-period, since rebalancing is initiated that point in
time. Consequently, when the default hypothetically occurs before the end of the single-period, that particular
loss is to some extent underestimated, as a slightly too low forward accrual rate is used to carry the loss to the
end of the capital horizon. The loss is essentially taken at a later point in time, resulting in a too short accrual
period. From another perspective, since the position is effectively left in the default state in the period of time
before rebalancing, it carries no risk in that period, resulting in a slight underestimation of the model implied
risk. The effects of these two complications are highly likely to be only marginal. Nevertheless, valuation
inconsistencies of this kind must be recognized in the assessment of the proposed incremental risk model. A
correction for the effects should be derivable, but that is beyond the scope of this study. Even though the
effect is likely to be very small, a correction is an obvious suggestion for improvement.
80
Only the correlation effect may change as a result of altering the forward accrual rate assumption. Nonetheless, this is consistent
with the conclusions that are presented in this study.
95
3.2.7 The Position of the Incremental Risk Model within the Basel II Framework
Apart of the model specific assessment of the effect of inputs, assumption and other model specifications,
there is one last much more general aspect of the incremental risk model that is worth discussing. This aspect
concerns the position of the incremental risk model or its resulting Incremental Risk Capital Charge within the
Basel II Market Risk Framework. In this study, a statistically defined default and migration risk model was
developed to produce a stylized example of an incremental risk model. In that sense, the resulting credit VaRbased Incremental Risk Capital Charge on itself is a statistically defined concept. Nonetheless, it is only a
single part of the eventual market risk capital charge that is based on the Basel II Market Risk Framework. To
assess what the eventual position of the incremental risk model is within the Market Risk Framework, and
more importantly what the overall intuition of the complete Market Risk Framework is, a decomposition is
required of the definition of market risk capital into its separate components.
The incremental risk model and its resulting Incremental Risk Capital Charge are part of the specific risk
charge of the Basel II Market Risk Framework. The proposed revisions to the Market Risk Framework set
forth a framework that is based on four different components (BCBS, 2009b). The first is the traditional tenday 99% VaR based on the banks market risk VaR model. The second component is the newly proposed
stressed ten-day 99% VaR, which is roughly equivalent to the traditional ten-day 99% VaR conditioned to a
year of economic turmoil. The sum of these two ten-day 99% VaR measures, although both subject to
different multipliers, constitute the general risk charge.81 The specific risk charge is comprised of the third
component, the Incremental Risk Capital Charge based on the one-year 99.9% incremental risk model VaR,
and the last component, which contains the remainder of the specific risk charge. The remainder of the
specific risk charge predominantly comprises the standardized specific risk charges for securitization and resecuritization exposures and capital charges for equity issuer risk.
Apart from some standardized specific risk charges, all components of the Basel II Market Risk Framework
are statistical definitions. Nevertheless, the definition of market risk capital is simply the sum of the four
different components. This simple definition is exactly where the largest problem of the entire framework lies.
Finger (2009), in his assessment of the incremental risk model, addresses this critical aspect as a recipe for
trouble. His criticizes the new capital rules since the individual components tease with the illusion of precision,
and yet the final aggregated number, the market risk capital definition, is nothing more than recipe. This lack
of meaning in the overarching market risk capital concept has also been a constant complaint in the industry
comments to the previous incremental risk model proposals (BCBS, 2007, 2008a). Basically, all the individual
models are devised to address specific risks in statistically meaningful ways, but the eventual market risk
capital charge has no real statistical relevance. The sum of two ten-day 99% market risk VaR measures, which
are both subject to multiplication factors, and a one-year 99.9% credit VaR has no statistical meaning and then
the remaining specific risk charges are even ignored.
Some statistical consistency can be obtained from the fact that under the Gaussian assumption and the
standard square root time scaling rule, a ten-day 99% VaR multiplied by three (the multiplication factor) is
roughly equivalent to a sixty-day 99.9% VaR. Sixty days is a very reasonable risk horizon in a trading
environment according to Finger (2009). Consequently, the market risk capital definition simplifies to the sum
of three different 99.9% VaR measures. Then following the Basel intuition, the most conservative measure
here should be the sum of the three measures. Nevertheless, as explained in Breuer et al. (2008), just adding
up the risk measures arising from different sorts of risks does not necessarily generate the most conservative
answer. In essence, risk measures resulting from the behaviour of simple models may add in simple ways and
therefore the proposed recipe will behave as desired, yet the danger is that it is unclear what will happen under
81
To compute the VaR-based general risk charge in the trading book, the traditional VaR is multiplied by M A and the stressed
VaR is multiplied by M only. The value of M is set by the banks regulatory supervisor and is based on their assessment of the
quality of the banks risk management system. The minimum value of M is equal to 3. The value of A is the result of the ex post
backtesting performance of the banks VaR model and its value is set in the range 0 to 1.
96
more complex realistic models. The behaviour of simple recipes, like the multiplication of a 99% VaR measure
by three, the multiplication factor, is easy to approach in new circumstances. Conversely, the behaviour of a
complicated recipe, like the sum of multiple to a large extend inconsistently defined VaR measures, in a new
environment is impossible to approach (Finger, 2009).
Fingers critique may not directly be relevant to the market risk capital context surrounding the stylized
incremental risk model that is produced in this study, but it unquestionably applies in general. The main
message is: Why bother to derive complex models to approach precise statistical definitions when the eventual
overarching concept has no statistical relevance and cannot even be justified under the argument of
conservatism? Moreover, why does a framework which is initially based on risk management purposes does
not produce an ultimate concept that is truly meaningful in actual risk management? Note that this critique is
not just relevant under the unrealistic assumption that a 99.9% VaR measure can be estimated accurately, but
its true relevance lies in to the violation of the Basel Committees concept of conservatism. In this context, it
is perhaps more constructive to strive for a larger coherent overarching model, as proposed by JPMorgan
Chase & Co. (Gilbert, 2009) and Goldman Sachs (Charnley, 2009), than maintaining a slowly growing bundle
of independent models that assess interacting risks. Herein, one cannot expect that such a larger model would
yield the correct risk measure estimates with the required precision at once, but it is the general objective that
is important here. The implementation of newly proposed revisions to the Basel II Market Risk Framework to
some extent translates more into the old Market Risk Framework plus an additional credit crisis add-on, than
that it pursuits to a better understanding of the management of the risks in the trading book. Nevertheless,
even such a credit crisis add-on is justified in the light of the burden the financial sector has placed on the
global economy and the violation of the social responsibility it is alleged to have.
97
98
CONCLUSIONS
he main objectives of this study were to construct and evaluate an incremental risk model and its resulting
Incremental Risk Capital Charge, as this newly introduced regulatory capital charge will become part of
the Basel II Market Risk Framework in the near future. Hence, banks will be required to develop and utilize
such a model in the computation of the minimum level of regulatory capital required for their trading book
positions. Consistent with the context in which this new capital charge and its underlying model currently
reside, multiple potential implications of this study were identified in the introduction. A distinction between
three related perspectives was made in this context as well: (1) regulation, (2) model development and (3)
model validation. Herein, the most obvious perspective is model development. The entire study, comprising
all aspects of the constructed incremental risk model as well as the numerous alternative approaches in the
estimation of its inputs, is relevant for modelling purposes, especially the set-up of the simulation model and
the extensive amount of evaluated possible model improvements.
In Part I, a complete multi-period simulation model was derived. In this main component of the proposed
incremental risk model, all relevant requirements, as prescribed by the Basel Committee, were incorporated.
The resulting simulation model is roughly equivalent to a sequence of (dependent) CreditMetrics models in
the time-series dimension, that accounts for potential rebalancing results at the end of the pre-specified
liquidity horizon of each position and in case of a simulated default. The relations between the stand-alone
migration and default risk, embedded in the positions that are evaluated in the model, are modelled with an
issuer correlation structure that is complementary to the simulation model. This correlation structure contains
both issuer asset correlation and issuer asset autocorrelation, and has been modelled and estimated under both
the Gaussian copula assumption as well as the much more realistic t-Student copula assumption. The
autocorrelation component in the correlation structure naturally generates the dependencies in the sequence
of CreditMetrics models. Moreover, the entire correlation structure is completely interchangeable, since nearly
every alternative correlation structure can be merged with the constructed multi-period simulation model. The
required (re)valuation of the evaluated positions within the model relies on the CreditMetrics forward
valuation approach. Consequently, and similar to the CreditMetrics model, any credit product of which the
expected future values can be computed under each possible credit rating at specific moments in the future
can be assessed with the model.
As stated, the proposed model set-up and the multitude of highlighted model improvements may provide
model developers with ideas and backgrounds for the development of an actual incremental risk model.
Moreover, regulators as well as model validators are provided with a somewhat stylized example of an
incremental risk model that may show them what type of model the proposed guidelines and principles are
likely to give rise to in practice.
In the modelling of the stand-alone risk, the model estimations have demonstrated that is it highly likely that
the utilization of different credit migration matrix estimation methodologies will not yield economic
differences in the eventual risk measures of the model. Nevertheless, the duration methodology is the only
estimation approach that allows for a highly detailed specification of credit migration dynamics, which is
potentially required in an actual incremental risk model. Herein, rating drift is addressed in the literature as the
most important additional risk factor in credit migration dynamics. Only the duration methodology allows for
an effective estimation of this effect, and thus provides the possibility of incorporating it in the simulation
model. Obviously, the existence of additional important stand-alone risk factors, such as rating drift, is highly
relevant as well in the model validation context.
The most imperative factor in the estimation of the credit migration matrix, however, is the sample period or
economic environment to which its estimates are conditional to. On this subject, the overarching Basel II
Framework offers two specification options: a through-to-cycle specification or a point-in-time specification.
The difference in the models risk measures that can be produced by both specifications can be extremely
sizeable, as demonstrated by the model estimations. As a consequence, the approach that is taken regarding
99
CONCLUSIONS
this specification, in the development or calibration of an actual incremental risk model, is of significant
importance in the model validation process. The dilemma is, however, that both specifications have their own
advantages and disadvantages. Essentially, there is no obvious right or wrong in this subject. In addition, the
prevention of regulatory capital arbitrage plays a central role here as well. To prevent this type of capital
arbitrage, regulators may prefer one of the two specifications to generate a consistency between the internal
ratings-based model and the incremental risk model of a bank, such that both models generate similar capital
charges for similar positions. Nevertheless, the Basel Committee has not provided guidance on this subject.
Hence, a regulatory implication offered by the results of this study, is that additional regulatory guidance on
this subject is likely to be warranted, since the effects of the type conditionality that is applied in the standalone risk specification are likely to be quite severe in any incremental risk model.
In the assessment of the issuer correlations within the model, the model estimations display indisputably that
the nature of the issuer correlations is the most important aspect in the correlation calibration in the model. In
essence, the copula assumption should be an accurate display of the actual nature of the asset correlations
between issuers, or more generally the nature of the credit quality correlations between issuers. Herein, an
accurate degree of the tail dependence is the most crucial aspect that the copula has to take into account, since
the effects of the copula assumption, as presented in this study, were mainly rooted in the differences in tail
dependence between the three copula specifications.
Furthermore, on the subject of the actual issuer asset correlation inputs that are inserted into the model, the
model estimations have demonstrated that the precision of the estimated issuer asset correlation coefficients
does not have to be exceedingly high in large long-short portfolios. One must ensure, however, that the
average level of asset correlations within the correlation structure of the model is accurately displayed. Hence,
in addition to the copula assumption, the calibration of the average level of issuer asset correlation is critical to
the validity of the model as well.
Conclusions of this kind are clearly even more important in the validation context than they are for model
developers. Essentially, the copula assumption is the most important input or assumption in the proposed
incremental risk model. This statement almost certainly applies in general, since the copula is very common
approach in the modelling of credit quality correlations between issuers. It is unquestionably one of the model
components on which emphasis must be placed in the validation process of any incremental risk model. In
the regulatory context, however, the Basel Committee has not touched the copula assumption or correlation
risk distribution assumption in the model guidelines. Hence, a major weakness of the current proposal is that
nothing, not even an ambiguous guideline, is specified here. It is understandable that banks are granted a
considerable degree of freedom in the development of this new model, yet the copula assumption or tail
dependence assumption is likely to be too important to be left unaddressed by regulators. The lack of
regulatory guidance here may give rise to the development of Gaussian models, while these models will
certainly underestimate the true migration and default risk underlying an actual trading portfolio, as such
models do not incorporate the tail dependence that certainly exists in reality.
As mentioned, the precision of the correlation estimates that are inserted into the model, via the correlation
structure, is not of vital importance in the estimation of the required risk measure. An accurate calibration of
the average level of issuer asset correlations, however, is crucial. Basically, in long-short portfolio a risk
reducing effect may be provided by the short positions, but this is by no means guaranteed. In addition, the
magnitude of this effect will change substantially when inputs such as the recovery rate(s) and credit yield
curves are adjusted. Perhaps, the most valid approach is to assess the average level of issuer asset correlations
per credit product class and/or segment of issuers. In that sense, the use of equity correlations is likely to be
accurate enough to capture the effects of the correlation risk within the portfolio that is evaluated with the
incremental risk model. Regular historical equity correlations may be applied, but equity correlation estimates
based on multiple factor models may provide a more accurate and more practical solution. Moreover, factor
models may allow for a more realistic and more complicated issuer correlation assessment as well. A
conversion of the issuer equity returns, that are utilized in the correlation estimation, into actual issuer asset
100
returns by applying the KMV asset value model, will further enhance the accuracy of the issuer correlation
estimates, resulting from both estimation approaches.
In addition to the equity correlation proxy, the estimation of issuer asset correlations with the use of observed
default rates was also assessed in the study. This approach, however, will almost certainly produce too low
issuer correlation coefficients and therefore a too low average level of issuer asset correlation. The source of
this effect lies in the scarcity of default data and the loss of detail generated by this issue. Consequently, the
correlation risk within a trading portfolio is almost certainly not appreciated to its full extent when this
methodology is applied. One might argue that this asset correlation estimation methodology, therefore, is not
to be considered a viable application option for a credit risk model such as the incremental risk model.
Obviously, this is valuable information for model validators as well.
Furthermore, similar to the credit migration matrix specification, conditionality may also be applied in the
issuer correlations in the model. One must, however, be cautious in the application of conditionality through
issuer correlations, since the model estimations have revealed that increased (credit crisis) issuer correlations
are not capable of fully reconstructing the actual downgrade and default cluster that was observed during the
credit crisis. Hence, a linear issuer asset correlation structure will be too simple to completely capture actual
credit quality relations between issuers, especially during episodes of economic turmoil.
The last element of the correlation structure of a multi-period incremental risk model is autocorrelation. The
model estimations have demonstrated that the incorporation of autocorrelation in the proposed model
induces a small but robust increase in the models risk measure. In essence, small to moderate effects as a
result of autocorrelation can be expected in general, since observed issuer autocorrelations tend to be quite
low. Even though it is not the most important risk source to account for in an incremental risk model,
autocorrelation should be present in a multi-period model, since it is one of the most commonly observed
phenomena in financial markets and it does effectively increase migration and default risk. Two modelling
approaches can be applied here. The first approach is a more general factor model based approach which may
become increasingly complicated as autoregressive and mean reversion elements are required. The second
approach is an issuer-specific historical autocorrelation approach, which may not be implementable when a
factor model is utilized in the correlation structure of the model.
The last and most important remark on the subject of autocorrelation is that when rating drift is incorporated
in the stand-alone risk specification model, then autocorrelation is not required in the correlation structure,
since both effectively address the same market inefficiency effect. In essence, a model set-up in which rating
drift is incorporated through the stand-alone risk specification is the most optimal solution, since rating drift is
addressed directly and probably more accurately in the form in which it is observed. In addition, the derivation
of the models correlation structure is simplified substantially when no autocorrelation is incorporated.
The last crucial aspect is the length of the liquidity horizons of the positions in the model. The applied
approach in the incorporation of the liquidity horizons in the simulation model is relevant in the modelling
context. More important is, however, that the Basel Committee intended to make the liquidity of trading
positions in stressed conditions an important factor in the incremental risk model. The model estimations
have demonstrated that this regulatory objective will almost certainly be reached, since the models risk
measures are rather sensitive to the length of the liquidity horizons of the positions in the model. Moreover,
this conclusion is likely to apply to the incremental risk model in general, as a similar incorporation of liquidity
horizon specification can be expected in an actual incremental risk model.
One additional comment here is that incorporation of liquidity effects through liquidity horizons does
produce a double assessment of liquidity, since the required credit yields also contain a liquidity component.
In fact, multiple theoretical as well as practical issues can be found in the constant level of risk and liquidity
horizon structure that is proposed by the Basel Committee. Essentially, actual trading and risk management
practices are likely to deviate from the behaviour implied by the constant level of risk assumption, especially in
an extreme market environment.
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CONCLUSIONS
Nevertheless, banks are once again forced to assess the liquidity of trading positions in an empirical form.
Regardless of the theoretical and the practical ambiguity accompanying the constant level of risk assumption
and its companion notion, the liquidity horizon, these model components will lead to discussion of the
liquidity topic and therefore promote transparency of liquidity risk (Finger, 2009). The introduction of the
concept of the liquidity horizon will open the door for the assessment of a relatively new concept in the credit
risk related literature. The development of such a research area is in fact warranted, since the model validation
standard will have to be based on some sort of theory, and more importantly it requires empirical results.
Since the liquidity horizons are certainly crucial inputs of the incremental risk model, the creation of liquidity
horizon benchmarks may be vital for model validation processes. The emphasis on the subject of liquidity may
in the end be the greatest contribution of the incremental risk model in all three perspectives.
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APPENDICES
A.1
THE TWO-PERIOD TWO-ISSUER CORRELATION CORRECTION

In the two period two issuer setting, two Gaussian copulas must be applied to construct standard normal
simulated issuer asset returns that are correlated in two dimensions. The single-period returns of these issuers
are defined as:
xA,1 and xAAC,2 for position A and xB ,1 and xBAC,2 for position B.
The objective here is as follows: xAAC,2 should be auto-correlated to xA,1 with autocorrelation coefficient A, AC
and xBAC,2 should be auto-correlated to xB ,1 with autocorrelation coefficient B , AC . The implied issuer correlation
should be equal to AB . Hence, corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) should take on the value of AB .
First, the issuer asset correlation is introduced in both periods:
2
xB ,1 x A,1 AB 1 AB
z1
2
and xB ,2 x A,2 AB 1 AB
z2 ,
(A.1)
(A.2)
where xA,1 , xA,2 , z1 and z2 are independent standard normally distribution random variables, implying
that xB ,1 and xB ,2 are also standard normally distributed random variables that are correlated to xA,1 and
xA,2 , respectively, with magnitude AB .
Subsequently, autocorrelation is introduced by applying the second Gaussian copula for both positions by
creating variables xAAC,2 and xBAC,2 , using xA,1 , xA,2 , xB ,1 and xB ,2 :
x AAC,2 x A,1 A, AC 1 B2 , AC xA,2
(A.3)
and xBAC,2 xB ,1 B , AC 1 B2, AC xB ,2 ,
(A.4)
where xAAC,2 and xBAC,2 are standard normally distributed and correlated to xA,1 and xB ,1 with magnitudes
A, AC and B , AC , respectively, as a result of the second Gaussian copula.
Using equations A.1, A.2, A.3 and A.4, it can be demonstrated that:
xA,1 xA,1 ,
(A.5)
2
,
xB ,1 x A,1 AB z1 1 AB
(A.6)
x AAC,2 x A,1 A, AC x A,2 1 A2 , AC ,
(A.7)
2
2
xBAC,2 x A,1 B , AC AB x A,2 1 B2 , AC AB z1 B , AC 1 AB
z2 1 AB
1 B2 , AC .
(A.8)
In the above equations, xA,1 , xB ,1 , xAAC,2 and xBAC,2 are expressed in terms of xA,1 , xA,2 , z1 and z2 , which are
all independent standard normally distribution random variables.
Here, the following statistical rule holds: when a ~ N(0,1) is correlated to b ~ N(0,1) and b is correlated to
c ~ N(0,1) , then the correlation between a and c is equal to corr(a, b) times corr(b, c) , or in more statistical
definitions: ac ab bc . The rule is employed to derive all correlations between xA,1 , xB ,1 , xAAC,2 and xBAC,2 in
terms of issuer correlation coefficient AB and autocorrelation coefficients A, AC and B , AC .
For example, the expression of corr( xB ,1 , xAAC,2 ) can be determined as follows. The expressions of xB ,1 and xAAC,2
are given above in equation A.6 and A.7. Both simulated issuer asset returns are created with the use of xA,1 .
The remainder of their formulations only contain uncorrelated independent terms. Hence, xB ,1 and xAAC,2 are
correlated through xA,1 only. Then, since xB ,1 xA,1 AB and xAAC,2 xA,1 A, AC (ignoring the uncorrelated
components) the above statistical rule can be applied, resulting in corr( xB ,1 , xAAC,2 ) AB A, AC .
103
APPENDICES
Appling this procedure, all correlations between xA,1 , xB ,1 , xAAC,2 and xBAC,2 can be derived:
corr( xA,1 , xB ,1 ) AB ,
(A.9)
corr( xA,1 , xBAC,2 ) AB B , AC ,
(A.10)
corr( xAAC,2 , xB ,1 ) AB A, AC ,
(A.11)
corr( x AAC,2 , xBAC,2 ) AB ( A, AC B , AC 1 A2 , AC 1 B2 , AC ) ,
(A.12)
corr( xA,1 , xAAC,2 ) A, AC ,
(A.13)
corr( xB ,1 , xBAC,2 ) B , AC .
(A.14)
The next step is to express corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) in terms of the derived correlations above. To accomplish
this, corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) must be defined. The standard correlation formula applies here:
cov( xA,1 xAAC,2 , xB ,1 xBAC,2 )

var( xA,1 xAAC,2 ) var( xB ,1 xBAC,2 )
(A.15)
The covariance term in equation A.15 is generally expressed as:

cov( xA,1 xAAC,2 , xB ,1 xBAC,2 ) E[(( xA,1 xAAC,2 ) E ( xA,1 xAAC,2 ))(( xB ,1 xBAC,2 ) E ( xB ,1 xBAC,2 ))] .
(A.16)
Since E ( xA,1 ) E ( xAAC,2 ) E ( xB ,1 ) E ( xBAC,2 ) 0 , this can be rewritten as:

cov( xA,1 xAAC,2 , xB ,1 xBAC,2 ) E ( xA,1 xB ,1 ) E ( xA,1 xBAC,2 ) E ( xB ,1 xAAC,2 ) E ( xAAC,2 xBAC,2 ) .
(A.17)
All individual terms in this expression are standard normally distributed. Hence, it can be rewritten as:
cov( xA,1 xAAC,2 , xB ,1 xBAC,2 ) corr( xA,1 , xB ,1 ) corr( xA,1 , xBAC,2 ) corr( xAAC,2 , xB ,1 ) corr( xAAC,2 , xBAC,2 ) .
(A.18)
The variance term in equation A.15 is a sum of to correlated variable, which is generally approached as:
var( xA,1 xAAC,2 ) var( xA,1 ) var( xAAC,2 ) 2cov( xA,1 , xAAC,2 ) .
(A.19)
In this expression, var( xA,1 ) var( xAAC,2 ) 1 and thus, cov( xA,1 , xAAC,2 ) corr( xA,1 , xAAC,2 ) .
Consequently, the variance term can be rewritten as:
var( xA,1 xAAC,2 ) 2 2corr( xA,1 , xAAC,2 ) .
(A.20)
The same applies to var( xB ,1 xBAC,2 ) :

var( xA,1 xAAC,2 ) 2 2corr( xA,1 , xAAC,2 ) .
(A.21)
By substituting the derived definitions of cov( xA,1 xAAC,2 , xB ,1 xBAC,2 ) , var( xA,1 xAAC,2 ) and var( xB ,1 xBAC,2 ) into the
correlation equation (equation A.15), the implied correlation can be expressed as:
corr( xA,1 , xB ,1 ) corr( xA,1 , xBAC,2 ) corr( xAAC,2 , xB ,1 ) corr( xAAC,2 , xBAC,2 )
2 2corr( xA,1 , xAAC,2 ) 2 2corr( xB ,1 , xBAC,2 )
(A.22)
Then, by substituting derivations of each correlation, as expressed in equation A.9, A.10, A.11, A.12, A.13 and
A.14, the implied correlation can be expressed in terms of issuer correlation and autocorrelations:
corr( x A,1 x AAC,2 , xB ,1 xBAC,2 ) AB
(2 2 A, AC )(2 2 B , AC )
(A.23)
This expression of the implied issuer correlation is based on only the correlation inputs in the correlation
structure. By rearranging equation A.23, a correction can be devised in which a corrected correlation value
104

*
( AB
) is created. This corrected correlation value should be inserted as the input in the correlation structure
instead of input correlation AB to ensure corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) is equal to estimated original input
correlation AB . The corrected correlation coefficient is derived as follows:
*
AB
AB /
(2 2 A, AC )(2 2 B , AC )
(A.24)
The input issuer correlation ( AB ) must be replaced in the model by the corrected input issuer correlation
*
*
( AB
). More specifically, AB
should be used in the application of the first copula for the single-period issuer
asset returns. This will ensure the implied issuer correlation in the model, corr( xA,1 xAAC,2 , xB ,1 xBAC,2 ) , is equal to
the original input issuer correlation AB , in a two-period, two-issuer correlation structure.
A.2
DEFAULT CORRELATION ESTIMATES

TABLE XII - Default Correlations
1.
2.
3.
4.
5.
1. Basic Materials
2. Communications
3. Consumer C.
4. Consumer NC.
5. Diversified
6. Energy
7. Financial
8. Industrial
9. Technology
10. Utilities
Autocorrelation
0.0224
0.0230
0.0139
0.0121
0.0045
0.0051
0.0028
0.0173
0.0148
-0.0015
0.0051
0.0230
0.0407
0.0165
0.0133
-0.0135
0.0143
0.0084
0.0275
0.0139
0.0017
0.0114
0.0139
0.0165
0.0118
0.0120
-0.0006
0.0070
0.0047
0.0132
0.0145
-0.0019
0.0017
0.0121
0.0133
0.0120
0.0157
0.0050
0.0077
0.0051
0.0118
0.0164
-0.0010
0.0028
0.0045
-0.0135
-0.0006
0.0050
0.0427
-0.0014
-0.0068
-0.0069
0.0112
-0.0056
-0.0074
6.
7.
8.
9.
10.
0.0051
0.0143
0.0070
0.0077
-0.0014
0.0131
0.0042
0.0100
0.0097
0.0002
0.0031
0.0028
0.0084
0.0047
0.0051
-0.0068
0.0042
0.0076
0.0035
0.0022
-0.0021
0.0012
0.0173
0.0275
0.0132
0.0118
-0.0069
0.0100
0.0035
0.0220
0.0158
0.0016
0.0035
0.0148
0.0139
0.0145
0.0164
0.0112
0.0097
0.0022
0.0158
0.0243
-0.0039
0.0057
-0.0015
0.0017
-0.0019
-0.0010
-0.0056
0.0002
-0.0021
0.0016
-0.0039
0.0085
0.0006
The upper matrix displays the default correlation between industries and within industries (the diagonal). The row under the matrix shows the
industry default autocorrelations. Consumer C. = Consumer Cyclical and Consumer NC. = Consumer Non-Cyclical. Both the underlying one-year
industry default probabilities and one-year joint default probabilities are created, using an issuer-weighted average of the relevant 10 one-year (joint)
default probabilities (one for each year in the estimation period). Both the underlying three-month industry default probabilities and three-month
joint default probabilities are created, using an issuer-weighted average of the relevant 40 and 39 three-month (joint) default probabilities (one for
each year in the estimation period), respectively.
A.3
CONSTITUENT LISTS OF THE CORPORATE BOND PORTFOLIOS

TABLE XIII - Constituent Lists of the Corporate Bond Portfolios
A. Long positions
Rating
AAA
AA
Value Position
$225,000
$200,000
Issuer
Automatic Data Processing Inc*
Pfizer Inc
Assured Guaranty Corp
Microsoft Corp
PACCAR Inc
Procter & Gamble Co/The
Sysco Corp
CME Group Inc
United Parcel Services Inc
Madison Gas & Electric Co
Northwest Natural Gas Co
Maturity
2
5
15
10
Coupon
3%
5%
7%
4%
Duration
1.97
4.55
9.98
8.30
3
12
5
4
4
15
9
6%
5%
5%
5%
4%
6%
7%
2.83
8.98
4.52
3.71
3.76
9.94
6.93
105
APPENDICES
TABLE XIII (continued)

Rating
A. Long positions
Value Position
$200,000
BBB
$150,000
BB
$150,000
$100,000
CCC/C
$50,000
Issuer
Maturity
Coupon
Duration
Nucor Corp
Walt Disney Co/The
AT&T Inc
Cintas Corp
Halliburton Co
Goldman Sachs Group Inc/The**
California Water Service Group
Cabot Corp
Amazon.com Inc
Newell Rubbermaid Inc
Harley-Davidson Inc
Apollo Investment Corp*
Astoria Financial Corp
Xerox Corp
8
10
4
15
1
4
10
5
3
10
5
12
4
12
6%
5%
7%
6%
5%
2%
6%
8%
8%
11%
15%
8%
6%
0%
6.47
7.85
3.61
9.75
1.00
3.87
7.61
4.28
2.77
6.60
3.91
7.82
3.65
12.00
Glatfelter
Constellation Brands Inc
DaVita Inc
Leucadia National Corp
Peabody Energy Corp
El Paso Corp
Jabil Circuit Inc
Century Aluminum Co
Ciena Corp*
Isle of Capri Casinos Inc
Interface Inc
Alliance One International Inc***
Headwaters Inc*
8
8
6
8
7
5
9
7
14
5
3
7
8
7%
7%
7%
7%
7%
6%
8%
8%
8%
7%
11%
9%
7%
6.07
6.07
4.96
6.07
5.54
4.38
6.38
5.32
7.45
4.27
2.68
5.21
5.93
RH Donnelley Inc
Standard Pacific Corp
Wolverine Tube Inc
Quantum Corp*
4
6
3
10
7%
7%
15%
10%
3.51
4.76
2.57
5.78
Maturity
10
3
9
3
9
10
7
Coupon
5%
4%
5%
6%
6%
5%
7%
Duration
8.04
2.88
7.41
2.83
7.11
7.90
5.74
B. Short positions
Rating
AAA
Value Position
-$225,000
Issuer
Johnson & Johnson
Exxon Mobil Corp*
Berkshire Hathaway Inc
WW Grainger Inc*
Wal-Mart Stores Inc
General Electric Co
Nicor Inc
AA
-$200,000
-$200,000
NIKE Inc
Amgen Inc
Public Storage
Hubbell Inc
Caterpillar Inc
3
8
5
11
7
6%
6%
7%
6%
6%
2.83
6.47
4.37
8.11
5.83
BBB
-$150,000
Southwest Airlines Co
Mattel Inc
Regency Centers LP
Waste Connections Inc
3
2
4
14
8%
6%
5%
3%
7.82
1.94
3.70
10.39
106
TABLE XIII (continued)

B. Short positions
Rating
BBB
Value Position
-$150,000
BB
-$150,000
-$100,000
CCC/C
-$50,000
Issuer
Black & Decker Corp
Maturity
7
Coupon
5%
Duration
5.92
Goodyear Tire & Rubber Co/The

Harman International Industries Inc*
URS Corp*
Greif Inc
Las Vegas Sands LLC
Jarden Corp
GSI Group Inc/United States
Greenbrier Cos Inc
15
3
5
8
6
8
5
7
7%
8%
6%
6%
7%
7%
12%
8%
8.37
2.76
4.38
6.24
4.90
5.93
3.95
5.32
Colonial BancGroup Inc/The

GenCorp
Advanced Micro Devices Inc
15
4
3
9%
9%
7%
6.44
3.41
2.76
* No existing bonds were found for this company. ** The exposure is enlarged to $800,000 in the concentrated long-short portfolio. *** The
exposure is enlarged to $500,000 in the concentrated long-short portfolio. The exposure of the (remaining) A-rated long positions is reduced to
$100,000 in the concentrated portfolio, while the position value of the (remaining) B-rated long positions is reduced to $20,000 in the concentrated
portfolio. All issuer ratings underlying the table are from 01/05/2009, as that is the model estimation date. Maturity and duration are both presented
in years. The applied credit yield curves in the valuation of the positions are those of 01/05/2009.
A.4
CREDIT CURVES
In the valuation and forward valuation of the corporate bonds in the portfolios, forwards zero credit curves
are required. Accordingly, credit yield curves are obtained and/or constructed and subsequently converted to
forward credit yield curves applying the traditional discrete-time forward rate formula. The credit curves that
are applied in this study are obtained from Bloomberg Professional. More specifically, USD Composite
Bloomberg Fair Value (BFV) Curves from 01/05/2009 are employed. These curves are available for the AA,
A, BBB, BB and B credit classes.
The CCC/C-curve, which is applied in the valuation of the CCC/C-issuers, is based on a combination of Cyields from the Merrill Lynch U.S. High Yield Cash Pay C-Rated Index and the Composite BFV B-Curve. The
Merrill Lynch index measures the performance of C-grade U.S. dollar denominated corporate bonds publicly
issued in the U.S. domestic market. Its yields are obtained from Thomson Datastream. Due to the very limited
CCC/C-category yield curve information available, the C-yields and B-yields are combined into a CCC/C yield
curve
For the AAA category, no BFV Composite Curve was available. The Composite BFV AAA-Curve was
originally available, but it was discontinued at March 31, 2009 due to the discontinuance of the BFV AAA
Financials Curve on which the Composite Curve was partially built. The other underlying and the only
remaining BFV AAA-Curve is the BFV AAA Industrials Curve. Hence, the BFV AAA Industrials Curve is
utilized to value the AAA-issuers, which will produce in quite realistic valuation estimates, since AAA-yields
do not tend to differ much across industries.
107
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112
ERNST & YOUNG

Financial Services Risk Management
ERASMUS UNIVERSITEIT ROTTERDAM
Erasmus School of Economics - Department of Finance

ABSTRACT / EXECUTIVE SUMMARY
In the light of the current global financial crisis, the Basel
Committee on Banking Supervision has released a third proposal
concerning the introduction of the incremental risk model and its
resultant regulatory capital charge. The purpose of this model is to
capture the migration and default risk embedded in the credit
products in the trading book of financial institutions, as the recent
episodes of financial turmoil have proven banks to be
undercapitalized, especially on those particular risks. Special
attention is devoted to the liquidity of the credit products in the
model guidelines as well. Hence, the Incremental Risk Capital
Charge must provide banks with an additional capital buffer
against migration and default risk as well as liquidity risk in the
trading book.
In this study, a multi-period incremental risk model is derived in
accordance with the Basel Committees principles and requirements.
The model structure is based on the CreditMetrics model (i.e.
Gupton et al., 1997), which is extended to a sequential multiperiod setting. In addition to the construction of the model, the
principal inputs of the model, the credit migration matrix and the
issuer credit quality correlations, are estimated with the use of
various alternative estimation methodologies. The issuer asset
correlation structure in the model displays both issuer correlation in
the cross-sectional dimension and autocorrelation in the time-series
dimension. The issuer asset correlation structure is modelled under
the Gaussian copula assumption as well as two different t-Student
copula specifications. Subsequently, the eventual model is estimated
with the use of three different corporate bond portfolios.
The resulting model estimations imply that the copula assumption
(or tail dependence specification) is the most vital input or
assumption in the model, since the required one-year 99.9% VaRestimates are highly sensitive to this particular specification. This
conclusion almost certainly applies to the incremental risk model in
general as well. In addition, the assumed lengths of the liquidity
horizons of the assessed positions, the applied conditionality in credit
migration matrix and the average level of issuer asset correlations in
the model are also highly likely to be crucial inputs or assumptions
in the estimation of the required risk measure in any incremental
risk model. Lastly, the precision of the issuer correlations in the
model seems to be much less crucial than anticipated. The same
applies to the choice in the methodology utilized in the estimation of
the credit migration matrix that is applied in the model.

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YANNICK VAN DER STEL

THE INCREMENTAL RISK MODEL

THE INCREMENTAL RISK MODEL

ABSTRACT / EXECUTIVE SUMMARY

Description of the Basel Committees Proposal

PART II: INPUT ESTIMATION

Credit Migration Matrices

PART III: MODEL ASSESSMENT

A.1 The Two-Period Two-Issuer Correlation Correction

A.4 Credit Curves

TABLES AND FIGURES

Credit Migration Matrix: Cohort Method

General Structure of the Incremental Risk Model

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

DESCRIPTION OF THE BASEL COMMITTEES PROPOSAL

In Part I of this study, first, a detailed

PART I: MODEL CONSTRUCTION

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

Loss due to default

Issuer and market

Constant level of risk assumption

1.2.2 The CreditMetrics Model

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION

P( BBB CCC / C) P(Z BBBD R Z BBBCCC/C ) (Z BBBCCC/C ) (Z BBBD ) ,

P( BBB B) P(Z BBBCCC/C R Z BBBB ) (Z BBBB ) (Z BBBCCC/C ) ,

P( BBB BB) P(Z BBBB R Z BBBBB ) (Z BBBBB ) (Z BBBB ) ,

P( BBB BBB) P(Z BBBBB R Z BBBBBB ) (Z BBBBBB ) (Z BBBBB ) ,

P( BBB A) P(Z BBBBBB R Z BBBA ) (Z BBBA ) (Z BBBBBB ) ,

P( BBB AA) P(Z BBBA R Z BBBAA ) (Z BBBAA ) (Z BBBA ) ,

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

THE MULTI-PERIOD SIMULATION MODEL

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

where n is the number of credit positions in the portfolio ( t is in months).

if CRt k 3,i D and k 3 qi h

for k 3,6,9,12 and i 1,..., n .

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION

for k 3,6,9,12 and i 1,..., n ,

if CRt k 3,i D and k 3 qi h

for k 3,6,9,12 and i 1,..., n , where CRt k ,i D .

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

for i 1,..., n , where Rt k ,i Vt CRk ,i Vt ICR

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION

ERASMUS UNIVERSITEIT ROTTERDAM - ERASMUS SCHOOL OF ECONOMICS

THE INCREMENTAL RISK MODEL

The (discounted) recovery rate commonly expressed as:

ERNST & YOUNG - FINANCIAL SERVICES RISK MANAGEMENT

PART I: MODEL CONSTRUCTION