Splitting Credit Risk into Systemic, Sectorial and Idiosyncratic Components

Alfonso Novales Cinca,Alvaro Chamizo

doi:10.2139/ssrn.3322246

Abstract

We provide a methodology to estimate a global credit risk factor from CDS spreads that can be very useful for risk management. The global risk factor (GRF) reproduces quite well the different episodes that have affected the market over the sample period. It has high correlation with standard credit indices, but it contains much higher explanatory power for fluctuations in CDS spreads across sectors than the credit indices themselves. The additional information content over iTraxx seems to be related to some financial rates. We first use the estimated GRF to analyze the extent to which the eleven sectors we consider are systemic. After that, we use it to split the credit risk of individual issuers into systemic, sectorial, and idiosyncratic components, and we perform some analyses to test that the estimated idiosyncratic components are actually firm-specific. The systemic and sectorial components explain around 65% of credit risk in the European industrial and financial firms and 50% in the North American firms in those sectors, with 35% and 50% of risk, respectively, having an idiosyncratic nature. Thus, there is a significant margin for portfolio diversification. We also show that our decomposition allows us to identify those firms whose credit would be harder to hedge. We end up analyzing the relationship between the estimated components of risk and some synthetic risk factors.

Highlights

The financial crisis has shown the importance of determining the main influences and characteristics of sovereign and corporate credit markets
We provide a methodology to estimate a global credit risk factor from credit default swaps (CDS) spreads that can be very useful for risk management
We end up analyzing the relationship between the estimated components of risk and some synthetic risk factors, in order to learn about the different nature of the credit risk components

Summary

INTRODUCTION

The financial crisis has shown the importance of determining the main influences and characteristics of sovereign and corporate credit markets. Besides evaluating the relevance of the systemic component of sectorial credit portfolios, and for estimating the sensitivity of sectorial indices to macroeconomic and financial indicators, we use the global risk factor for stress testing global and sectorial credit portfolios. We use our global risk factor to decompose credit risk at the level of the firm into systemic, sectorial and idiosyncratic components This decomposition of risk for the industrial and financial sectors points to relatively large idiosyncratic components of risk that are still larger in North American than in European firms, which may be due to a lack of liquidity. We conclude with a summary of the main findings

LITERATURE REVIEW

THE DATA

EXAMINING THE HISTORIC DATA

SYSTEMIC AND IDIOSYNCRATIC COMPONENTS OF CREDIT RISK IN SECTORIAL PORTFOLIOS

DECOMPOSITION OF RISK AT THE LEVEL OF THE FIRM

Findings

CONCLUSIONS