TITLE:
The Impact of Asset Price Bubbles on Credit Risk Measures
AUTHORS:
Michael Jacobs Jr.
KEYWORDS:
Financial Crisis, Credit Risk, Model Risk, Asset Price Bubbles, Expected Loss, Credit Val-Ue-At-Risk, Stochastic Differential Equations, Probability of Default, Loss Given Default, Constant Elasticity of Variance, Cox-Ingersoll-Ross
JOURNAL NAME:
Journal of Financial Risk Management,
Vol.4 No.4,
November
30,
2015
ABSTRACT: This study presents an analysis of the impact of asset price bubbles on standard credit risk measures, including Expected Loss (“EL”) and Credit Value-at-Risk (“CVaR”). We present a styled model of asset price bubbles in continuous time, and perform a simulation experiment of a 2 dimensional Stochastic Differential Equation (“SDE”) system for asset value determining Probability of Default (“PD”) through a Constant Elasticity of Variance (“CEV”) process, as well as a correlated a Loss-Given-Default (“LGD”) through a mean reverting Cox-Ingersoll-Ross (“CIR”) process having a long-run mean dependent upon the asset value. Comparing bubble to non-bubble economies, it is shown that asset price bubbles may cause an obligor’s traditional credit risk measures, such as EL and CVaR to decline, due to a reduction in both the standard deviation and right skewness of the credit loss distribution. We propose a new risk measure in the credit risk literature to account for losses associated with a bubble bursting, the Expected Holding Period Credit Loss (“EHPCL”), a phenomenon that must be taken into consideration for the proper determination of economic capital for both credit risk management and measurement purposes.