Redesigning Credit Risk Modeling Chapter4

In my book serialization, I promise the upcoming chapters get more interesting. Chapter 4 is the last part of the beginning.

Ch 1: Introduction, Ch 2: What is the Goal, Ch. 3 Defining Yield, Ch. 4 Defining Volatility

My first analytics jobs was predicting currency futures. From Day 1 you learn that high-volatility returns are of limited value. A better metric to optimize is the Sharpe Ratio = yield / volatility IN YIELD, or something similar. Somehow our industry got locked into the mindset that Losses = Volatility. That is absolutely untrue. Losses are an expense that is part of Yield. The volatility of losses, which can be called economic capital when done right, are part of the volatility in yield. To perform sensible portfolio optimization we need to measure yield volatility and stop calling predictable losses volatility.

Bob Oliver wrote a widely cited paper in 2001 about the efficient frontier in lending. The very first citations of his paper misunderstood his work to imply that optimizing a loan portfolio meant looking for tradeoffs between yield and losses. That is not what he said and that is not the efficient frontier, but even ChatGPT now misquotes the definition of the efficient frontier in lending. No wonder almost no one bothers with portfolio optimization. If this is your starting point, it doesn't work.

And to top it off, instrument correlations are computed wrong. You cannot get the correlation matrix that you need for portfolio optimization by correlating loss rate time series. Yes, it should be based on yield, but even then, it needs to be the correlation between unpredictable volatility in yields for different instruments. Predictable volatility is called a lifecycle, or maturation function, or hazard function. Also, changing cut-off scores changes your predictable losses. Only after you normalize for the lifecycle and expected credit risk variation can you compute a correlation matrix on the residuals.

All of this can be done with known methods. Just don't define volatility as losses and you're half way there.

If you're just tuning in, I'm providing free highlights, chapter by chapter, of my nearly free little book of ideas. I hope you find some of it useful.

Joseph Breeden
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