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Portfolio Default Losses Driven by Idiosyncratic Risk
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Portfolio Default Losses Driven by Idiosyncratic Risk

Shaoying Chen, Zhiwei Tong and Yang Yang
SSRN Electronic Journal
2023
DOI: 10.2139/ssrn.4626393
url
https://doi.org/10.2139/ssrn.4626393View
Preprint (Author's original)This preprint has not been evaluated by subject experts through peer review. Preprints may undergo extensive changes and/or become peer-reviewed journal articles. Open Access

Abstract

We consider a general portfolio of assets with low individual default risk and study the probability of the portfolio default loss exceeding an arbitrary threshold. The latent variables driving defaults are modeled by a mixture structure, which combines common shock, systematic risk, and idiosyncratic risk factors. While common shocks and systematic risk have been found by many studies to contribute significantly to portfolio losses, the role of idiosyncratic risk is often neglected, despite its high relevance for unbalanced or under-diversified portfolios. This study focuses on heavy-tailed idiosyncratic risk factors and explores two distinct scenarios among them: an independence scenario and an asymptotic dependence scenario. The former is standard in the literature, while the latter is motivated by some recent studies that have found the inadequacy of relying solely on common factors to capture default clustering or sovereign default spreads. This consideration also reflects the possibility that idiosyncratic reasons can trigger contagion among firms with liabilities in each other. Our main results establish asymptotic equivalences for the exceedance probability of the portfolio loss as the representative default probability approaches zero. These results highlight the significance of dominant idiosyncratic risk factors and their dependence in portfolio losses.

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