Integrating Interest Rate Risk in Credit Portfolio Models

A typical shortcoming of most current credit portfolio models is the lack of a stochastic modeling of risk factors, such as interest rates or credit spreads, during the revaluation process at the risk horizon. Within the simple credit risk model underlying the Internal Ratings-based approach of Basel II with incorporated correlated interest rate risk the effect which results from neglecting the stochastic nature of market risk factors is shown for an infinitely large, homogeneous portfolio of defaultable coupon bonds. The consequence of ignoring interest rate risk can be a significant underestimation of the economic capital needed as a protection against unexpected losses. The lower the correlation of the firms’ asset returns, the lower the unconditional default probability and the longer the bonds’ time to maturity, the higher is the difference between the VaR with and without considering interest rate risk during the revaluation process at the risk horizon.