Abstract
This chapter describes several approaches and techniques that are useful for modeling credit risk in a portfolio setting. Two key concepts in the modeling of portfolio credit risk are default correlation and the loss distribution function. The basic model discussed in this chapter allows one to take a closer quantitative look at these concepts. The chapter also includes a simple approach for modeling the credit risk in a portfolio and describes three basic methods for deriving a portfolio's loss distribution function. The first method involves the analytical derivation of the loss distribution function. The second technique is the large-portfolio approximation motivated by the work of Vasicek and others. The third is a simple simulation-based method that can also be used for small portfolios. The chapter also highlights the key role that default correlation plays in determining the range of likely losses that can be experienced in a portfolio.
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