Credit Risk Decomposition for Asset Allocation

We provide a methodology for credit risk analysis that can be embedded into a risk appetite framework. We analyze the information content in CDS spreads to estimate the systematic and idiosyncratic components of credit risk for CDS issuers in the industrial sector of Europe. Such decomposition should be an important tool for the evaluation of the diversification possibilities of credit portfolios or for the design of appropriate hedging strategies. It could be used by financial institutions to maintain their risk limits when taking their asset allocation decisions as well as by supervisors investigating potential systematic risk problems. The analysis could be extended to other sectors.