Forecasting Industry Sector Default Rates through Dynamic Factor Models

Journal of Risk Model Validation, Vol. 2, No. 3, Fall 2008

Posted: 19 May 2009

See all articles by Giuseppe Missaglia

Giuseppe Missaglia

BNL

Andrea Cipollini

University of Palermo - d/SEAS; Università degli studi di Modena e Reggio Emilia (UNIMORE) - Faculty of Business and Economics; Università degli studi di Modena e Reggio Emilia (UNIMORE) - Center for Research in Banking and Finance (CEFIN)

Multiple version iconThere are 2 versions of this paper

Date Written: October 10, 2008

Abstract

In this paper we use a reduced form model for the analysis of Portfolio Credit Risk. For this purpose, we fit a Dynamic Factor model, DF, to a large dataset of default rates proxies and macrovariables for Italy. Multi step ahead density and probability forecasts are obtained by employing both the direct and indirect method of prediction together with stochastic simulation of the DF model. We, first, find that the direct method is the best performer regarding the out of sample projection of financial distressful events. In a second stage of the analysis, we find that reduced form Portfolio Credit Risk measures obtained through DF are lower than the one corresponding to the Internal Ratings Based analytic formula suggested by Basel 2. Moreover, the direct method of forecasting gives the smallest Portfolio Credit Risk measures. Finally, when using the indirect method of forecasting, the simulation results suggest that an increase in the number of dynamic factors (for a given number of principal components) increases Portfolio Credit Risk.

Keywords: Dynamic Factor Model, Forecasting, Stochastic Simulation, Risk Management, Banking

JEL Classification: C32, C53, E17, G21, G33

Suggested Citation

Missaglia, Giuseppe and Cipollini, Andrea, Forecasting Industry Sector Default Rates through Dynamic Factor Models (October 10, 2008). Journal of Risk Model Validation, Vol. 2, No. 3, Fall 2008 . Available at SSRN: https://ssrn.com/abstract=1406860

Giuseppe Missaglia

BNL ( email )

Rome
Italy

Andrea Cipollini (Contact Author)

University of Palermo - d/SEAS ( email )

Viale delle Scienze, edificio 13
Palermo, 90124
Italy

Università degli studi di Modena e Reggio Emilia (UNIMORE) - Faculty of Business and Economics ( email )

Viale Berengario 51
41100 Modena, Modena 41100
Italy

Università degli studi di Modena e Reggio Emilia (UNIMORE) - Center for Research in Banking and Finance (CEFIN) ( email )

via Berengario 51
Modena, modena I-41100
Italy

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