sectoral concentration

[ajsa]

Hi David,

"Discuss the potential impact of sectoral concentration on capital requirements within the Basel II IRB model.
•The authors find that the market model produces an estimate of economic capital that is 10% to 90% higher than the sector model"

Could you explain what the market model and sector model are? I understand that sectoral concentration will lead underestimation for IRB model.

thanks.

 

[David Harper CFA FRM]

Hi ajsa,

It's an unfortunate AIM without, in my opinion, much relevance... it refers to one of the cited studies, I had to look it up:
(source: (Duellmann K, M Scheicher, and C Schmieder (2006): Asset correlations and credit portfolio risk – an empirical analysis, working paper)

1. A single factor / “market” model, in which correlation is modelled by a single common risk factor defined as the returns of the aggregate portfolio of all firms in the sample.
2. A multi-factor / “sector” model, in which the systematic risk factors are linked to industry sectors. We further differentiate between correlations of firms in the same sector (intra-sector correlations) and correlations across sectors involving the correlation between pairs of sector indices (inter-sector correlations).

so their "market model" is similar to Basel IRB ASRF approach and the sector model has multiple industry factors. Then they simulate credit risk (EC) based on the different correlation models (where market model is based on company specific correlation to single factor). Then they say their finding is probably due to large firms (biasing the sample) or noise, so frankly it's a muddy concentration conclusion ... our assignment can only salvage this: "In summary, these empirical results highlight the important role played by correlation estimates and model structure in the measurement of portfolio concentration risk. The potential variability of asset correlation patterns over time is an issue of particular importance."

(I wish GARP would vet AIMs like this ... it won't be tested ... it had a muddy point ... oh well)

David