A Simple Multi-Factor “Factor Adjustment” for Credit Capital Diversification
Garcia Cespedes J. C., Keinin A., de Juan Herrero J. A. and Rosen D., 2006, Journal of Credit Risk, (2)3.
We present a simple adjustment to the single-factor credit capital model, which recognizes the diversification from a multi-factor model. We introduce the concept of a diversification factor at the portfolio level, and show that it can be expressed as a function of two parameters that broadly capture the sector concentration and the average cross-sector correlation. The model further supports an intuitive capital allocation methodology through the definition of marginal diversification factors at the sector or obligor level. We estimate the diversification factor for a family of models, and show that it can be expressed in parametric form or tabulated for potential regulatory applications and risk management. As a risk management tool, it can be used to understand concentration risk, capital allocation and sensitivities, stress testing, as well as to compute “real-time” marginal risk.