A Two-Factor Model for PD and LGD Correlation

25 Pages Posted: 22 Sep 2009 Last revised: 7 Mar 2011

See all articles by Jiri Witzany

Jiri Witzany

University of Economics in Prague

Date Written: February 7, 2011

Abstract

The paper proposes a two-factor model to capture retail portfolio probability of default (PD) and loss given default (LGD) parameters and in particular their mutual correlation. We argue that the standard one-factor models standing behind the Basel II formula and used by a number of studies cannot capture well the correlation between PD and LGD on a large (asymptotic) portfolio. Parameters of the proposed model are estimated using the Markov Chain Monte Carlo (MCMC) method on a sample of real banking data. The results confirm positive stand-alone PD and LGD correlations and indicate a positive mutual PD x LGD correlation. The estimated Bayesian MCMC distributions of the parameters show that the stand alone correlations are strongly significant with a lower significance of the mutual correlation probably due to a too short observed time period.

Keywords: credit risk, recovery rate, loss given default, correlation, regulatory capital

JEL Classification: G21, G28, C14

Suggested Citation

Witzany, Jiri, A Two-Factor Model for PD and LGD Correlation (February 7, 2011). Available at SSRN: https://ssrn.com/abstract=1476305 or http://dx.doi.org/10.2139/ssrn.1476305

Jiri Witzany (Contact Author)

University of Economics in Prague ( email )

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

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