Benchmarking LGD Discount Rates

42 Pages Posted: 27 Sep 2020

See all articles by Harald (Harry) Scheule

Harald (Harry) Scheule

University of Technology Sydney (UTS) - School of Finance and Economics; Financial Research Network

Stephan Jortzik

Independent

Date Written: August 13, 2020

Abstract

This paper provides a theoretical and empirical analysis of alternative discount rate concepts for computing LGDs using historical bank workout data. It benchmarks five discount rate concepts for workout recovery cash flows to derive observed Loss rates Given Default (LGDs) in terms of economic robustness and empirical implications: contract rate at origination, loan weighted average cost of capital, return on equity, market return on defaulted debt, and market equilibrium return. The paper develops guiding principles for LGD discount rates and argues that the Weighted Average Cost of Capital (WACC) and market equilibrium return dominate the popular contract rate method. The empirical analysis of data provided by Global Credit Data (GCD) shows that declining risk-free rates are in part offset by increasing market risk premiums. Common empirical discount rates are between the risk-free rate and the return on equity. The variation of empirical LGDs is moderate for the various discount rate approaches. Furthermore, a simple correction technique for resolution bias is developed and increases observed LGDs for all periods, particularly recent periods.

Keywords: Default, Discount rates, Global Credit Data, LGD, Recovery, Resolution, Systematic risk

JEL Classification: G20, G28, C51

Suggested Citation

Scheule, Harald and Jortzik, Stephan, Benchmarking LGD Discount Rates (August 13, 2020). Available at SSRN: https://ssrn.com/abstract=3673120 or http://dx.doi.org/10.2139/ssrn.3673120

Harald Scheule (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

P.O. Box 123
Broadway, NSW 2007
Australia

HOME PAGE: http://https://www.uts.edu.au/staff/harald.scheule

Financial Research Network ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Stephan Jortzik

Independent ( email )

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