Chapter

Global Business Cycles and Credit Risk

M. Hashem Pesaran, Til Schuermann and Björn-Jakob Treutler

in The Risks of Financial Institutions

Published by University of Chicago Press

Published in print February 2007 | ISBN: 9780226092850
Published online February 2013 | e-ISBN: 9780226092980 | DOI: http://dx.doi.org/10.7208/chicago/9780226092980.003.0010
Global Business Cycles and Credit Risk

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This chapter presents evidence of considerably larger benefits of credit diversification than are implied by current workhorse models. The global vector autoregressive macroeconometric model presents forecasts of all the global variables that directly or indirectly affect the returns. Changes in equity prices, interest rates, and oil prices remain the key driving factors in multifactor regressions. Heterogeneity is vital in controlling risk, both under a baseline forecast and under shock scenarios. Full firm-level parameter heterogeneity matters a great deal for capturing differences in simulated credit loss distributions. The shape of the loss distribution is significantly influenced under neglected heterogeneity, in which case the resulting pricing and risk assessment would in turn be significantly affected. It is shown that the size of the portfolio needed to eradicate most of the idiosyncratic risk, and thus fully exploit the diversification potential that exists in credit portfolios, may be in the thousands.

Keywords: credit diversification; workhorse models; equity prices; interest rates; oil prices; heterogeneity; credit loss distributions; idiosyncratic risk

Chapter.  20399 words.  Illustrated.

Subjects: Financial Markets

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