Modeling the Default Risk Charge (DRC) Using the Intensity Model

The last regulation of the Fundamental Review of the Trading Book (FRTB) proposed to replace the Incremental Risk Charge (IRC) with the Default Risk Charge (DRC). Since, many studies were implemented to give the adequate model and the impact of this change. As we know in the modeling area, we always deem many assumptions during the conception and the implementation. These assumptions impact the results of the model output and they are sometimes verified or not in the market. The two commonly assumptions considered on the DRC modeling are: the default is implemented in the structural model (for example Merton model) and the Gaussian copula for correlations between issuers. However, the Merton model could not catch the default for the positions with very small probability of default. Hence, this approach arises a model risk, and we study in this paper the impact of this assumption using the intensity model to compute the value of the DRC to quantify this risk kind