Interaction of Market and Credit Risk: An analysis of inter-risk correlation and risk aggregation

by Klaus Böcker of UniCredit Group, and
Martin Hillebrand of Munich University of Technology

June 27, 2007

Abstract: In this paper, we investigate the interaction between a credit portfolio and another risk type, which can be thought of as market risk. Combining Merton-like factor models for credit risk with linear factor models for market risk, we analytically calculate their inter-risk correlation and show how inter-risk correlation bounds can be derived. Moreover, we elaborate how our model naturally leads to a Gaussian copula approach for describing dependence between both risk types. In particular, we suggest estimators for the correlation parameter of the Gaussian copula that can be used for general credit portfolios. Finally, we use our findings to calculate aggregated risk capital of a sample portfolio both by numerical and analytical techniques.

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