Local Logit Regression for Recovery Rate
42 Pages Posted: 16 Oct 2017 Last revised: 17 Oct 2017
Date Written: October 16, 2017
We propose a flexible and robust non-parametric local logit regression for modelling and predicting defaulted loans' recovery rates that lie in [0,1]. Applying the model to the widely studied Moody's recovery dataset and estimating it by a data-driven method, the local logit regression uncovers the underlying nonlinear relationship between the recovery and covariates, which include loan/borrower characteristics and economic conditions. We find some significant nonlinear marginal and interaction effects of conditioning variables on recoveries of defaulted loans. The presence of such nonlinear economic effects enriches the local logit model specification that supports the improved recovery prediction. This paper is the first to study a non-parametric regression model that not only generates unbiased and improved recovery predictions of defaulted loans relative to the parametric counterparts, it also facilitates reliable inference on marginal and interaction effects of loan/borrower characteristics and economic conditions. Moreover, incorporating these nonlinear marginal and interaction effects, we improve the specification of parametric regression for fractional response variable, which we call a "calibrated" model, the predictive performance of which is comparable to that of local logit model. This calibrated parametric model will be attractive to applied researchers and industry professionals working in the risk management area and unfamiliar with non-parametric machinery.
Keywords: loss given default, credit risk, nonlinearity, kernel estimation, defaulted debt, simulation
JEL Classification: C14, C53, G02, G32
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