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Vasicek's Model of Distribution of Losses in Large Homogeneous Portfolios LBS 2012 PDF
Vasicek's Model of Distribution of Losses in Large Homogeneous Portfolios LBS 2012 PDF
Vasicek’s Model
• Important method for calculating distribution of
loan losses:
widely used in banking
used in Basel II regulations to set bank capital
requirements
• Motivation linked to distance-to-default analysis
• But, model of dependence is Gaussian Copula again
• Key assumptions (apart from Gaussian dependence)
homogeneous portfolio (equal investment in each credit)
very large number of credits
ε i = ρ m + 1 − ρ vi , i = 1,K N
and
corr (ε i , ε j ) = ρ
• Where m and vi are independent N(0,1) random variables
and ρ is common to all firms
• Notice that if vi ~ N(0,1) and m ~ N(0,1) then εi ~ N(0,1)
RD ,i − ( µi − 12 σ V2 ,i )T RD ,i − ( µi − 12 σ V2 ,i )T
p ≡ Prob ε i < = N
σ V ,i T σ T
i
• In this model we assume that the default probability, p, is
constant across firms
ε i = ρ m + 1 − ρ vi
• Default occurs when:
RD ,i − ( µi − 12 σ V2 ,i )
ε i = ρ m + 1 − ρ vi < = N −1 ( p )
σ V ,i T
or
N −1 ( p ) − ρ m
vi <
1− ρ
N −1 ( p ) − ρ m
vi <
1− ρ
N −1 ( p ) − ρ m
Prob(default m )= Prob vi <
1 − ρ
N −1 ( p) − ρ m
= N = θ (m), say
1− ρ
N −1 ( p ) − ρ m
and therfore = = N −1 (θ ( m))
1− ρ
Hi corr
Lo corr
N −1 ( p ) − 1 − ρ N −1 (θ )
Prob ( L < θ ) = prob ( m > m(θ ) ) = prob m >
ρ
N −1 ( p ) − 1 − ρ N −1 (θ )
= N −
ρ
1 − ρ N −1 (θ ) − N −1 ( p )
Prob ( L < θ ) = N
ρ
0.08
0.05
0.04
0.03
0.02
0.01
0
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00%
Portfolio Loan Loss (%(
Source: Vasicek
RD ,i − ( µi − 12 σ V2 ,i )
ε i = ρ m + 1 − ρ vi < = N −1 ( p )
σ V ,i T
εi ≤ ε *
εi ≤ ε *
1
τ i = − ln(1 − U i ) ≤ τ * where U i = N (ε i )
λ
Example
• Intensity
model with
1000 names
and equal
intensity
and Vasicek
model with
equal
default
probability
and
correlation
Applications
• Vasicek’s obtains a formula for the distribution of
losses with:
single common factor
homogeneous portfolio
large number of credits
• But the approach can be generalised to a much
more realistic (multi-factor) correlation structure
and granularity in the portfolio holdings
quite widely used in banking for management of
risk of loan portfolio