Integrating default risk in the historical simulation model

We describe a new model for generating credit risk scenarios in the StatPro Simulation Model. Starting from the historical series of asset swap indices grouped by sector, currency, and rating, we can derive a number of equivalent time series for the zero volatility spreads(or z-spreads). The current credit risk of an asset is modeled using the z-spread so computed. In order to simulate the change of credit risk from one day to another we employ two different procedures depending on the availability of a default probability structure for the given issuer. The first method, namely the static method, relies purely on the issuer rating for obtaining the spread scenarios. The second method, namely the dynamic method, interpolates a fractional rating to accurately position the given issuer between ratings. Interestingly, the dynamic method gives an immediate response to event risk since the approach reflects the risk that is embedded in the market-quoted default probability structure.

Keywords: historical scenarios, full-repricing, StatPro, market risk, default risk, risk, risk simulation, pricing functions, interest rates, bond pricing, derivatives, fractional rating, static method, dynamic method

Pdf file: default-risk-hist-simulations.pdf


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