Risk Management of a Credit Portfolio: An Alternative to Structural Approach

The reduced form models have been widely used in the literature to price the credit risk of defaultable assets. However, little has yet been done in using the reduced form model as a portfolio risk management tool. In this study, we propose a multi-firm reduced form model and use it to measure portfolio credit risk. We calibrate and back-test our model using corporate bond prices. Our results suggest that the implied hazard rate of our model can be a leading indicator of the creditworthiness of the firm. Moreover, credit risk is found to be highly systematic and the back-testing results suggest that discontinuity in hazard rate is needed to capture the occurrence of extreme loss events. ∗Joseph L. Rotman School of Management, University of Toronto, tel: (416) 525-2818, e-mail: [email protected]. I would like to thank my thesis supervisor Alan White and all the participants of the Learning Session (April 2002) of the Risk Management Group of Bank of Montreal, including Frederick Shen, Bogie Ozdemir, Stephen Bates, Scott Allen, Alexander Tchernitser, Paul Kim and Chaoyang Guo for their comments. I do not implicate any of these people in the errors that remain.