Integrating Credit and Market Risk: A Factor Copula based Method

AbstractThis paper presents a factor copula model for the integration of Chinese commercial banks’ credit risk and market risk. By defining the dependence structure through a set of common factors reflecting the macro-economic situation, this model reveals the intrinsic correlation between credit risk and market risk. We derive the integration process with factor copula and generate common factors by performing a principal component analysis on 4 different macro-economic indicators that have impact on bank's profit, namely the GDP growth, M2 growth, benchmark for loan rate, and the ratio of new loans to GDP. In the empirical study, 15 Chinese listed banks are chosen to construct the model. The results are compared with that of elliptical copulas and Archimedean copulas, we find that factor copula gives a more prudential result in risk integration