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Default Probability Estimation in Small Samples - With an Application to Sovereign Bonds

Discussion Papers in Statistics and Econometrics, University of Cologne, No. 05/2011

24 Pages Posted: 28 Sep 2011 Last revised: 9 Feb 2012

Walter Orth

University of Cologne - Department of Statistics and Econometrics

Date Written: September 28, 2011

Abstract

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

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

Walter Orth (Contact Author)

University of Cologne - Department of Statistics and Econometrics ( email )

Albertus-Magnus-Platz
Cologne, DE 50923
Germany
(0049) 0221-470-6561 (Phone)

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