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Monte Carlo Simulation of Economic Capital Requirement & Default Protection Premium

This paper presents a simulation framework for measuring and managing the default risk of a loan portfolio. The economic capital requirement is explored for a hypothetical credit portfolio through the dependency of counterparty default on a systematic risk factor. The study employs bivariate standard normal distribution for mapping asset return correlations into default correlations. Monte Carlo simulations are employed to approximate the loss distribution and estimate various risk measures. The analysis performed shows that the Asymptotic Single Risk Factor (ASRF) model is a fast way for generating heavy-tailed credit loss distributions. Further, complete analytic derivation of Basel II-IRB risk weight functions are reported. The paper also comments on the pricing of single-period Portfolio Default Swaps.