MIE1622H - Assignment 3

MIE 1622H: Assignment 3 – Credit Risk Modeling and Simulation
Dr. Oleksandr Romanko

March 5, 2018
Due: Friday, March 23, 2018, not later than 6:00 p.m.
Use MATLAB for all MIE 1622H assignments.
You should hand in:

• Your report.
• Compress all of your MATLAB code files and output files into a file StudentID.zip (which
can be uncompressed by 7-zip (http://www.7-zip.org) software under Windows), and sub-
mit it via Blackboard portal no later than 6:00 p.m. on March 23.
Where to hand in: Online via Blackboard portal, both your code and report.
Introduction
The purpose of this assignment is to model a credit-risky portfolio of corporate bonds. Consider a
structural model for portfolio credit risk described in class. Using the data for 100 counterparties,
simulate 1-year losses for each corporate bond. You will need to generate 3 sets of scenarios:
• Monte Carlo approximation 1 : 5000 in-sample scenarios (N = 1000 · 5 = 5000 (1000 systemic
scenarios and 5 idiosyncratic scenarios for each systemic), non-Normal distribution of losses);
• Monte Carlo approximation 2 : 5000 in-sample scenarios (N = 5000 (5000 systemic scenarios
and 1 idiosyncratic scenario for each systemic), non-Normal distribution of losses);
• True distribution: 100000 out-of-sample scenarios (N = 100000 (100000 systemic scenarios

and 1 idiosyncratic scenario for each systemic), non-Normal distribution of losses).
The out-of-sample scenarios represent true distribution of portfolio losses. Two in-sample non-
Normal datasets are used for evaluating sampling error and performing portfolio optimization
(portfolio credit-risk optimization is the subject of Assignment 4).
To evaluate model error (if we wrongly assumed that counterparty losses follow Normal distri-
bution), compute mean loss and standard deviation of losses for each corporate bond from the
3 scenario sets (N =1000x5, 5000, 100000). This 3 in-sample sets are referred as in-sample Normal
model.
Evaluate VaR and CVaR at quantile levels 99% and 99.9% for the two portfolios:
(1) equal value (dollar amount) is invested in each of 100 bonds;
(2) one unit invested in each of 100 bonds;

For each portfolio, compute VaR and CVaR at quantile levels 99% and 99.9% for each of the six
datasets (non-Normal with N =1000x5, 5000, 100000; and Normal with mean/standard deviation
computed from N =1000x5, 5000, 100000). Compare each in-sample VaR and CVaR to out-of-
sample VaR and CVaR. Explain the effects of sampling error and model error.
To better evaluate sampling and model errors, perform the experiment 100 times in the following
way: generate in-sample datasets with N =1000x5 and 5000 (non-Normal and Normal) one hundred
times and compute VaR and CVaR. Keep the out-of-sample scenario set unchanged. Perform
analysis of the results for the 100 trials, e.g., compute averages of the results for 100 trials, analyze
standard deviation over 100 trials, etc.
Questions
1. (70 %) Implement portfolio credit risk simulation model in MATLAB:
There is a file credit risk simul.m on the course web-page. You are required to complete
the code in the file.
2. (20 %) Analyze your results:

• Produce the following output from your MATLAB code:
Portfolio 1:
Out-of-sample: VaR 99.0% = ..., CVaR 99.0% = ...

In-sample MC1: VaR 99.0% = ..., CVaR 99.0% = ...
In-sample MC2: VaR 99.0% = ..., CVaR 99.0% = ...
In-sample No: VaR 99.0% = ..., CVaR 99.0% = ...
In-sample N1: VaR 99.0% = ..., CVaR 99.0% = ...
In-sample N2: VaR 99.0% = ..., CVaR 99.0% = ...

...
Portfolio 2:

...
• Plot loss distributions in MATLAB that illustrate both out-of-sample and in-sample
results. Include plots that help illustrating your analysis in the report.
• Analyze sampling error when comparing non-Normal approximations to the true (out-of-
sample) loss distribution. Analyze model error when comparing Normal approximations
to the true (out-of-sample) loss distribution.
3. (10 %) Discuss possible strategies for minimizing impacts of sampling and model
errors:
• If you report the in-sample VaR and CVaR to decision-makers in your bank, what
consequences for the bank capital requirements it may have?
• Can you suggest techniques for minimizing impacts of sampling and model errors?
2
MATLAB Script to be Completed
clear all;
clc
format long;
Nout = 100000; % number of out-of-sample scenarios

Nin = 5000; % number of in-sample scenarios
Ns = 5; % number of idiosyncratic scenarios for each systemic
C = 8; % number of credit states
% Filename to save out-of-sample scenarios

filename_save_out = ’scen_out’;
% Read and parse instrument data

instr_data = dlmread(’instrum_data.csv’, ’,’);
instr_id = instr_data(:,1); % ID
driver = instr_data(:,2); % credit driver
beta = instr_data(:,3); % beta (sensitivity to credit driver)
recov_rate = instr_data(:,4); % expected recovery rate
value = instr_data(:,5); % value
prob = instr_data(:,6:6+C-1); % credit-state migration probabilities (default to A)
exposure = instr_data(:,6+C:6+2*C-1); % credit-state migration exposures (default to A)
retn = instr_data(:,6+2*C); % market returns
K = size(instr_data, 1); % number of counterparties
% Read matrix of correlations for credit drivers

rho = dlmread(’credit_driver_corr.csv’, ’\t’);
sqrt_rho = (chol(rho))’; % Cholesky decomp of rho (for generating correlated Normal random numbers)
disp(’======= Credit Risk Model with Credit-State Migrations =======’)

disp(’============== Monte Carlo Scenario Generation ===============’)
disp(’ ’)
disp(’ ’)
disp([’ Number of out-of-sample Monte Carlo scenarios = ’ int2str(Nout)])
disp([’ Number of in-sample Monte Carlo scenarios = ’ int2str(Nin)])
disp([’ Number of counterparties = ’ int2str(K)])
disp(’ ’)
% Find credit-state for each counterparty

% 8 = AAA, 7 = AA, 6 = A, 5 = BBB, 4 = BB, 3 = B, 2 = CCC, 1 = default
[Ltemp, CS] = max(prob, [], 2);
clear Ltemp
% Account for default recoveries

exposure(:, 1) = (1-recov_rate) .* exposure(:, 1);
% Compute credit-state boundaries

CS_Bdry = norminv( cumsum(prob(:,1:C-1), 2) );
% -------- Insert your code here -------- %
if(~exist(’scenarios_out.mat’,’file’))
for s = 1:Nout
end
% Calculated out-of-sample losses (100000 x 100)

% Losses_out
save(’scenarios_out’, ’Losses_out’)
else
load(’scenarios_out’, ’Losses_out’)
3
end
% Normal approximation computed from out-of-sample scenarios

mu_l = mean(Losses_out)’;
var_l = cov(Losses_out);
% Compute portfolio weights

portf_v = sum(value); % portfolio value
w0{1} = value / portf_v; % asset weights (portfolio 1)
w0{2} = ones(K, 1) / K; % asset weights (portfolio 2)
x0{1} = (portf_v ./ value) .* w0{1}; % asset units (portfolio 1)
x0{2} = (portf_v ./ value) .* w0{2}; % asset units (portfolio 2)
% Quantile levels (99%, 99.9%)

alphas = [0.99 0.999];
% Compute VaR and CVaR (non-Normal and Normal) for 100000 scenarios
for(portN = 1:2)
for(q=1:length(alphas))
alf = alphas(q);
% VaRinN(portN,q) = ...
% VaRinN(portN,q) = ...
% CVaRout(portN,q) = ...
% CVaRinN(portN,q) = ...
end
end
% Perform 100 trials

N_trials = 100;
for(tr=1:N_trials)
% Monte Carlo approximation 1
for s = 1:ceil(Nin/Ns) % systemic scenarios

for si = 1:Ns % idiosyncratic scenarios for each systemic
end
end
% Calculated losses for MC1 approximation (5000 x 100)

% Losses_inMC1
% Monte Carlo approximation 2
for s = 1:Nin % systemic scenarios (1 idiosyncratic scenario for each systemic)

end
% Calculated losses for MC2 approximation (5000 x 100)

% Losses_inMC2
% Compute VaR and CVaR

for(portN = 1:2)
alf = alphas(q);
% Compute portfolio loss
% portf_loss_inMC1 = ...
% portf_loss_inMC2 = ...
mu_MCl = mean(Losses_inMC1)’;
4
var_MCl = cov(Losses_inMC1);
mu_MC2 = mean(Losses_inMC2)’;
var_MC2 = cov(Losses_inMC2);
% Compute portfolio mean loss mu_p_MC1 and portfolio standard deviation of losses sigma_p_MC1
% Compute portfolio mean loss mu_p_MC2 and portfolio standard deviation of losses sigma_p_MC2
% Compute VaR and CVaR for the current trial
% VaRinMC1{portN,q}(tr) = ...
% VaRinMC2{portN,q}(tr) = ...
% VaRinN1{portN,q}(tr) = ...
% VaRinN2{portN,q}(tr) = ...
% CVaRinMC1{portN,q}(tr) = ...
% CVaRinMC2{portN,q}(tr) = ...
% CVaRinN1{portN,q}(tr) = ...
% CVaRinN2{portN,q}(tr) = ...
end
end
end
% Display portfolio VaR and CVaR

for(portN = 1:2)
fprintf(’\nPortfolio %d:\n\n’, portN)
alf = alphas(q);
fprintf(’Out-of-sample: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n’,
100*alf, VaRout(portN,q), 100*alf, CVaRout(portN,q))
fprintf(’In-sample MC1: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n’,
100*alf, mean(VaRinMC1{portN,q}), 100*alf, mean(CVaRinMC1{portN,q}))
fprintf(’In-sample MC2: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n’,
100*alf, mean(VaRinMC2{portN,q}), 100*alf, mean(CVaRinMC2{portN,q}))
fprintf(’ In-sample No: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n’,
100*alf, VaRinN(portN,q), 100*alf, CVaRinN(portN,q))
fprintf(’ In-sample N1: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n’,
100*alf, mean(VaRinN1{portN,q}), 100*alf, mean(CVaRinN1{portN,q}))
fprintf(’ In-sample N2: VaR %4.1f%% = $%6.2f, CVaR %4.1f%% = $%6.2f\n\n’,
100*alf, mean(VaRinN2{portN,q}), 100*alf, mean(CVaRinN2{portN,q}))
end
end
% Plot results
% figure(1);
% figure(2);

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MIE 1622H: Assignment 3 – Credit Risk Modeling and Simulation

Dr. Oleksandr Romanko

Use MATLAB for all MIE 1622H assignments.

You should hand in:

• True distribution: 100000 out-of-sample scenarios (N = 100000 (100000 systemic scenarios

(1) equal value (dollar amount) is invested in each of 100 bonds;

(2) one unit invested in each of 100 bonds;

1. (70 %) Implement portfolio credit risk simulation model in MATLAB:

2. (20 %) Analyze your results:

Out-of-sample: VaR 99.0% = ..., CVaR 99.0% = ...

Out-of-sample: VaR 99.9% = ..., CVaR 99.9% = ...

Out-of-sample: VaR 99.0% = ..., CVaR 99.0% = ...

Nout = 100000; % number of out-of-sample scenarios

C = 8; % number of credit states

% Filename to save out-of-sample scenarios

% Read and parse instrument data

K = size(instr_data, 1); % number of counterparties

% Read matrix of correlations for credit drivers

disp(’======= Credit Risk Model with Credit-State Migrations =======’)

% Find credit-state for each counterparty

% Account for default recoveries

% Compute credit-state boundaries

% -------- Insert your code here -------- %

% -------- Insert your code here -------- %

% Calculated out-of-sample losses (100000 x 100)

% Normal approximation computed from out-of-sample scenarios

% Compute portfolio weights

% Quantile levels (99%, 99.9%)

% Perform 100 trials

% Monte Carlo approximation 1

% -------- Insert your code here -------- %

for s = 1:ceil(Nin/Ns) % systemic scenarios

% Calculated losses for MC1 approximation (5000 x 100)

% Monte Carlo approximation 2

% -------- Insert your code here -------- %

for s = 1:Nin % systemic scenarios (1 idiosyncratic scenario for each systemic)

% Calculated losses for MC2 approximation (5000 x 100)

% Compute VaR and CVaR

% Display portfolio VaR and CVaR

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