Credit Risk [20]

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Bullet points include: Common assumption: correlations between latent variables equal correlations between the obligors’ equity returns (if available). In principle, alternatives include bond spread change correlations or default data correlations, but equity returns simplest to access. C.f. Merton model for firm. In practice, instead of actual obligor specific equity returns, it is common to use returns on weighted average of industry and country equity indices plus idiosyncratic noise. C.f. discussion of factor risk models described in session on market risk

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