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Credit Securitisations and Derivatives: Challenges for the Global Markets by Harald Scheule, Daniel Rösch

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7

Monte Carlo Methods for Portfolio Credit Risk

Tim J. Brereton1, Dirk P. Kroese1 and Joshua C. Chan2

1The University of Queensland

2Australian National University

7.1 INTRODUCTION

The financial crisis of 2007–2009 began with a major failure in the credit markets. The causes of this failure stretch far beyond inadequate mathematical modeling (see Donnelly and Embrechts (2010) and Brigo et al. (2009) for detailed discussions from a mathematical finance perspective). Nevertheless, it is clear that some of the more popular models of credit risk were shown to be flawed. Many of these models were and are popular because they are mathematically tractable, allowing easy computation of various risk measures. More realistic (and complex) models come at a significant computational cost, often requiring Monte Carlo methods to estimate quantities of interest.

The purpose of this chapter is to survey the Monte Carlo techniques that are used in portfolio credit risk modeling. We discuss various approaches for modeling the dependencies between individual components of a portfolio and focus on two principal risk measures: Value at Risk (VaR) and Expected Shortfall (ES).

The efficient estimation of credit risk measures is often computationally expensive, as it involves the estimation of small quantiles. Rare-event simulation techniques such as importance sampling can significantly reduce the computational burden, but the choice of a good importance sampling distribution can be a difficult mathematical ...

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