Measuring portfolio credit risk correctly: Why parameter uncertainty matters

Why should risk management systems account for parameter uncertainty? In addressing this question, the paper lets an investor in a credit portfolio face non-diversifiable uncertainty about two risk parameters - probability of default and asset-return correlation - and calibrates this uncertainty to a lower bound on estimation noise. In this context, a Bayesian inference procedure is essential for deriving and analyzing the main result, i.e. that parameter uncertainty raises substantially the tail risk perceived by the investor. Since a measure of tail risk that incorporates parameter uncertainty is computationally demanding, the paper also derives a closed-form approximation to such a measure. (C) 2010 Elsevier B.V. All rights reserved.