Firm Heterogeneity and Credit Risk Diversification

Joint with: Samuel G. Hanson, Harvard University and M. Hashem Pesaran, Faculty of Economics, University of Cambridge

This paper examines the impact of neglected heterogeneity on credit risk. We show that neglecting heterogeneity in firm returns and/or default thresholds leads to under estimation of expected losses (EL), and its effect on portfolio risk is ambiguous. But once EL is controlled

for, neglecting parameter heterogeneity leads to overestimation of risk. Using a portfolio of U.S. firms we illustrate that heterogeneity in the default threshold or probability of default,measured for instance by a credit rating, is of first order importance in affecting the shape ofthe loss distribution: including ratings heterogeneity alone results in a 20% drop in loss volatility and a 40% drop in 99.9% VaR, the level to which the risk weights of the New Basel Accord are calibrated.

For more information, contact Vee Roberson.