Dynamic factor analysis of industry sector default rates and implication for portfolio credit risk modelling

In this paper we use a reduced form model for the analysis of Portfolio Credit Risk. For this purpose, we fit a Dynamic Factor model, DF, to a large dataset of default rates proxies and macrovariables for Italy. Multi step ahead density and probability forecasts are obtained by employing both the direct and indirect method of prediction together with stochastic simulation of the DF model. We, first, find that the direct method is the best performer regarding the out of sample projection of financial distressful events. In a second stage of the analysis, we find that reduced form Portfolio Credit Risk measures obtained through DF are lower than the one corresponding to the Internal Ratings Based analytic formula suggested by Basel 2. Moreover, the direct method of forecasting gives the smallest Portfolio Credit Risk measures. Finally, when using the indirect method of forecasting, the simulation results suggest that an increase in the number of dynamic
factors (for a given number of principal components) increases Portfolio Credit Risk.