Integrating market and credit risk: A simulation and optimisation perspective

Abstract

We introduce a modelling paradigm which integrates credit risk and market risk in describing the random dynamical behaviour of the underlying fixed income assets. We then consider an asset and liability management (ALM) problem and develop a multistage stochastic programming model which focuses on optimum risk decisions. These models exploit the dynamical multiperiod structure of credit risk and provide insight into the corrective recourse decisions whereby issues such as the timing risk of default is appropriately taken into consideration. We also present an index tracking model in which risk is measured (and optimised) by the CVaR of the tracking portfolio in relation to the index. In-sample as well as out-of-sample (backtesting) experiments are undertaken to validate our approach. The main benefits of backtesting, that is, ex-post analysis are that (a) we gain insight into asset allocation decisions, and (b) we are able to demonstrate the feasibility and flexibility of the chosen framework.