Simulation analysis of correlation and credit migration models for credit portfolios

The market for derivatives such as first-to-default baskets and CDO tranches on portfolios of corporate credit exposures (bonds, loans, default swaps, etc.) has grown rapidly in recent years. Various models for capturing portfolio correlation effects have been introduced, with default time models becoming the most widely used. While attractive for their relative simplicity and ability, in some cases, to allow fast computation of hedge ratios, there is increasing concern around the limitations and implications of these models. This paper uses simulation to study the effects of credit migration and correlation assumptions underlying the models for valuation of derivatives on credit portfolios.