Creating and validating risk models [20]

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Bullet points include: Common to assume returns (whether of equities or of variables driving credit exposures) satisfy factor structures Factors often identified with returns on particular country and industry factors E.g. latent variables that generate shocks to credit quality / equity returns for i’th name include 2 industry factors ai,j and 2 country factors bi,j plus an idiosyncratic term i (j = 1 to 2, each factor/idiosyncratic component having zero mean and unit variance) For xi also to have unit variance we can without loss of generality re-parameterise as follows, with  suitably defined:

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