Loss, Default, and Loss Given Default Modeling

IES Working Paper No. 9/2009

23 Pages Posted: 12 Feb 2009 Last revised: 13 Feb 2009

See all articles by Jiri Witzany

Jiri Witzany

University of Economics in Prague

Date Written: February 12, 2009

Abstract

The goal of the Basle II regulatory formula is to model the unexpected loss on a loan portfolio. The regulatory formula is based on an asymptotic portfolio unexpected default rate estimation that is multiplied by an estimate of the loss given default parameter. This simplification leads to a surprising phenomenon when the resulting regulatory capital depends on the definition of default that plays the role of a frontier between the unexpected default rate estimate and the LGD parameter whose unexpected development is not modeled at all or only partially. We study the phenomenon in the context of single-factor models where default and loss given default are driven by one systemic factor and by one or more idiosyncratic factors. In this theoretical framework we propose and analyze a relatively simple remedy of the problem requiring that the LGD parameter be estimated as a quantile on the required probability level.

Keywords: credit risk, correlation, recovery rate, regulatory capital

JEL Classification: G21, G28, C14

Suggested Citation

Witzany, Jiri, Loss, Default, and Loss Given Default Modeling (February 12, 2009). IES Working Paper No. 9/2009. Available at SSRN: https://ssrn.com/abstract=1341564 or http://dx.doi.org/10.2139/ssrn.1341564

Jiri Witzany (Contact Author)

University of Economics in Prague ( email )

Winston Churchilla Sq. 4
Prague 3, 130 67
Czech Republic

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