Affine Model for Credit Risk Analysis

by Christian Gouriéroux of CREST & CEPREMAP & the University of Toronto,
Alain Monfort of CNAM & CREST, and
Vassilis Polimenis of the University of California

November 2005

Abstract: Continuous time affine models have been recently introduced in the theoretical financial literature on credit risk. They provide a coherent modelling, rather easy to implement, but have not yet encountered the expected success among practitioners and regulators. This is likely due to a lack of flexibility of these models, which often implied poor fit, especially compared to more ad hoc approaches proposed by the industry. The aim of this paper is to explain that this lack of flexibility is mainly due to the continuous time assumption. We develop a discrete time affine analysis of credit risk, explain how different types of factors can be introduced to capture separately the term structure of default correlation, of default heterogeneity, of correlation between default and loss-given-default; we also explain, why the factor dynamics are less constrained in discrete time and are able for instance to reproduce complicated cycle effects... These models are finally used to derive a CreditVaR and various decompositions of the spreads for corporate bonds or first-to-default basket.

JEL Classification: C41, G21.

Keywords: Term Structure, Credit Risk, Loss-Given-Default, Affine Model, Stochastic Discount Factor, Affine Process, Car Process,WAR process, Through-the- Cycle.

Published in: Journal of Financial Econometrics, Vol. 4, No. 3, (Summer 2006), pp. 494-530.

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