The Tail that Wags the Dog: Integrating Credit Risk in Asset Portfolios

Abstract

Tails are of paramount importance in shaping the risk profile of portfolios with credit risk sensitive securities. In this context risk management tools require simulations that accurately capture the tails, and optimization models that limit tail effects. Ignoring the tails in the simulation or using inadequate optimization metrics can have significant effects and destroy portfolio efficiency. The resulting portfolio risk profile can be grossly misrepresented when long run performance is optimized without consideration of the short term tail effects. This paper illustrates the pitfalls and suggests models for avoiding them.

Keywords: Credit risk, simulations, scenario analysis, conditional value at risk, optimization

JEL Classification: C61, G11, G12