Estimating Default and Recovery Rate Correlations

Institute of Economic Studies (IES), Faculty of Social Sciences, Charles University in Prague, Working Paper 03/2013

28 Pages Posted: 4 Apr 2013 Last revised: 24 May 2013

See all articles by Jiri Witzany

Jiri Witzany

University of Economics in Prague

Date Written: February 11, 2013

Abstract

The paper analyzes a two-factor credit risk model allowing to capture default and recovery rate variation, their mutual correlation, and dependence on various explanatory variables. At the same time, it allows computing analytically the unexpected credit loss. We propose and empirically implement estimation of the model based on aggregate and exposure level Moody’s default and recovery data. The results confirm existence of significantly positive default and recovery rate correlation. We empirically compare the unexpected loss estimates based on the reduced two-factor model with Monte Carlo simulation results, and with the current regulatory formula outputs. The results show a very good performance of the proposed analytical formula which could feasibly replace the current regulatory formula.

Keywords: credit risk, Basel II regulation, default rates, recovery rates, correlation

JEL Classification: G20, G28, C51

Suggested Citation

Witzany, Jiri, Estimating Default and Recovery Rate Correlations (February 11, 2013). Institute of Economic Studies (IES), Faculty of Social Sciences, Charles University in Prague, Working Paper 03/2013. Available at SSRN: https://ssrn.com/abstract=2242457 or http://dx.doi.org/10.2139/ssrn.2242457

Jiri Witzany (Contact Author)

University of Economics in Prague ( email )

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

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