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A Bottom-Up Dynamic Model of Portfolio Credit Risk. Part I: Markov Copula Perspective

Chapter in book
Authors Tomasz R. Bielecki
Areski Cousin
Stéphane Crépey
Alexander Herbertsson
Published in Recent Advances in Financial Engineering 2012
Pages 25-49
ISBN 978-981-4571-63-0
Publisher World Scientific
Place of publication New Jersey London Hong Kong
Publication year 2014
Published at Department of Economics
Pages 25-49
Language en
Links www.worldscientific.com/worldsciboo...
Keywords Portfolio credit risk, Credit derivatives, Markov copula model, Common shocks, Dynamic hedging
Subject categories Applied mathematics, Mathematical statistics, Economics and Business

Abstract

We consider a bottom-up Markovian copula model of portfolio credit risk where instantaneous contagion is possible in the form of simultaneous defaults. Due to the Markovian copula nature of the model, calibration of marginals and dependence parameters can be performed separately using a two-steps procedure, much like in a standard static copula set-up. In this sense this model solves the bottom-up top-down puzzle which the CDO industry had been trying to do for a long time. It can be applied to any dynamic credit issue like consistent valuation and hedging of CDSs, CDOs and counterparty risk on credit portfolios.

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