Skip to Main Content
HBS Home
  • About
  • Academic Programs
  • Alumni
  • Faculty & Research
  • Baker Library
  • Giving
  • Harvard Business Review
  • Initiatives
  • News
  • Recruit
  • Map / Directions
Faculty & Research
  • Faculty
  • Research
  • Featured Topics
  • Academic Units
  • …→
  • Harvard Business School→
  • Faculty & Research→
Publications
Publications
  • September 2008
  • Article
  • Journal of Empirical Finance

Firm Heterogeneity and Credit Risk Diversification

By: Samuel G. Hanson, M. Hashem Pesaran and Til Schuermann
  • Format:Print
  • | Pages:30
ShareBar

Abstract

This paper examines the impact of neglected heterogeneity on credit risk. We show that neglecting heterogeneity in firm returns and/or default thresholds leads to under estimation of expected losses (EL), and its effect on portfolio risk is ambiguous. Once EL is controlled for, the impact of neglecting parameter heterogeneity is complex and depends on the source and degree of heterogeneity. We show that ignoring differences in default thresholds results in overestimation of risk, while ignoring differences in return correlations yields ambiguous results. Our empirical application, designed to be typical and representative, combines both and shows that neglected heterogeneity results in overestimation of risk. Using a portfolio of U.S. firms we illustrate that heterogeneity in the default threshold or probability of default, measured for instance by a credit rating, is of first order importance in affecting the shape of the loss distribution: including ratings heterogeneity alone results in a 20% drop in loss volatility and a 40% drop in 99.9% VaR, the level to which the risk weights of the New Basel Accord are calibrated.

Keywords

Volatility; Credit; Investment Return; Outcome or Result; Risk and Uncertainty; Loss; Diversification; Complexity; United States

Citation

Hanson, Samuel G., M. Hashem Pesaran, and Til Schuermann. "Firm Heterogeneity and Credit Risk Diversification." Journal of Empirical Finance 15, no. 4 (September 2008): 583–612.
  • Find it at Harvard

About The Author

Samuel G. Hanson

Finance
→More Publications

More from the Authors

    • 2022
    • Faculty Research

    Demand-and-Supply Imbalance Risk and Long-Term Swap Spreads

    By: Samuel G. Hanson, Aytek Malkhozov and Gyuri Venter
    • April 2022
    • Journal of Finance

    Predictable Financial Crises

    By: Robin Greenwood, Samuel G. Hanson, Andrei Shleifer and Jakob Ahm Sørensen
    • January 2022 (Revised January 2022)
    • Faculty Research

    The Impact Developers Fund

    By: Malcolm Baker, Samuel Gregory Hanson, Jonathan Wallen and Zach Komes
More from the Authors
  • Demand-and-Supply Imbalance Risk and Long-Term Swap Spreads By: Samuel G. Hanson, Aytek Malkhozov and Gyuri Venter
  • Predictable Financial Crises By: Robin Greenwood, Samuel G. Hanson, Andrei Shleifer and Jakob Ahm Sørensen
  • The Impact Developers Fund By: Malcolm Baker, Samuel Gregory Hanson, Jonathan Wallen and Zach Komes
ǁ
Campus Map
Harvard Business School
Soldiers Field
Boston, MA 02163
→Map & Directions
→More Contact Information
  • Make a Gift
  • Site Map
  • Jobs
  • Harvard University
  • Trademarks
  • Policies
  • Accessibility
  • Digital Accessibility
Copyright © President & Fellows of Harvard College