Systematic risk factors redefined

Credit risk factor models tend to have a narrow focus on the Gaussian case, use copula functions that don’t work well with the martingale methods used in pricing, and can introduce arbitrage. Dariusz Gatarek and Juliusz Jablecki show how an increasing sequence of default times can be used to create systematic factors that allow for a rich correlation structure – and keep strong links with pricing

The credit valuation adjustment (CVA) that is added to derivatives prices to reflect the risk of the counterparty’s default is a particularly visible example of the need for the dependence between market and credit risks to be captured consistently. Because it is calculated on a netting set basis, large quantities of assets must be simulated simultaneously, with a dependence structure capturing their joint distribution – and that of their default times.

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