Scenario Analysis with the DD-PD Mapping Approach: Stock Market Shocks and U.S. Corporate Default Risk

Abstract

This paper introduces the quantile regression- based Distance-to-Default to Probability of Default (DD-PD) mapping, which links individual firms’ DD to their real world PD. Since changes in the DD depend on a handful of parameters, the mapping easily accommodates shocks arising from quantitative and narrative scenarios informed by expert judgment. At end-2020, risks from stock market corrections in the U.S. are concentrated in the energy, financial and technology sectors, and additional bank capital needs could be large. The paper concludes discussing uses of the mapping beyond PD valuation suitable for capital structure analysis, credit portfolio management, and long-term scenario planning analysis.

Keywords: probability of default, distance-to-default, default risk, stock markets, quantile regression, scenario analysis, stress test

JEL Classification: C22, C53, G32