Discussion Papers in Statistics and Econometrics, University of Cologne, No. 05/2011
24 Pages Posted: 28 Sep 2011 Last revised: 9 Feb 2012
Date Written: September 28, 2011
In small samples and especially in the case of small true default probabilities, standard approaches to credit default probability estimation have certain drawbacks. Most importantly, standard estimators tend to underestimate the true default probability which is of course an undesirable property from the perspective of prudent risk management. As an alternative, we present an empirical Bayes approach to default probability estimation and apply the estimator to a comprehensive sample of Standard & Poor's rated sovereign bonds. We further investigate the properties of a standard estimator and the empirical Bayes estimator by means of a simulation study. We show that the empirical Bayes estimator is more conservative and more precise under realistic data generating processes.
Keywords: Low-default portfolios, empirical Bayes, sovereign default risk, Basel II
JEL Classification: C11, C41, G15, G28
Suggested Citation: Suggested Citation
Orth, Walter, Default Probability Estimation in Small Samples - With an Application to Sovereign Bonds (September 28, 2011). Discussion Papers in Statistics and Econometrics, University of Cologne, No. 05/2011. Available at SSRN: https://ssrn.com/abstract=1934808 or http://dx.doi.org/10.2139/ssrn.1934808