Copulas and credit models

Latent variable models of default are used extensively both in internal credit rating methodologies and in the pricing of exotic credit derivatives. But, as Rüdiger Frey, Alexander McNeil and Mark Nyfeler demonstrate using the copula formalism, such models are badly specified using default correlation and, worse still, can expose users to considerable model risk

In this article, we focus on the latent variable approach to modelling credit portfolio losses. This methodology underlies all models that descend from Merton’s firm-value model (Merton, 1974). In particular, it underlies the most important industry models, such as those proposed by KMV Corporation and CreditMetrics.

Copulas and credit models