Risk management tools that capture systematic sources of credit
Widening credit spreads and rising default rates characterized the credit environment of the years 1997–2002. Attracted by historically high yield pickups, many new investors have entered the arena in this period. Many of them suffered significant losses due to one or more of the credit blowups like WorldCom, Enron and TXU Europe. Therefore, the demand for risk management tools for credit portfolios has increased rapidly. But cases of fraud and corporate malfeasance suggest that risk management tools that capture systematic sources of variations in returns are not enough. Sufficient diversification of investments provides effective protection against credit events.
Subsequently we will discuss how relative and absolute portfolio risk are related to diversification. Yet, too much diversification reduces the potential to generate alpha. A study by Dynkin et al. (2002) suggests that there is an optimal level of diversification that depends upon the skill in credit research.