Modeling Expected Loss with Unobservable Heterogeneity

52 Pages Posted: 20 Mar 2006

See all articles by Sudheer Chava

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Catalina Stefanescu

ESMT European School of Management and Technology

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business

Date Written: March 15, 2006

Abstract

In this paper we model the expected loss over multi-year horizons. Investors usually have only incomplete information about the true state of a firm. To model this form of unobservable heterogeneity, we introduce a latent non-negative random variable into the model specification of the probability of default and the recovery rate. To estimate the expected loss over arbitrary horizons, we estimate the coefficients for the stochastic processes describing the covariates for the probability of default for each obligor and the loss given default. We provide an analysis of both in and out of sample performance of our estimates of the probability of default and the loss given default.

Keywords: Default, Bankruptcy, Recovery Rate, Frailty, Unobservable Heterogeneity

JEL Classification: G33, C41

Suggested Citation

Chava, Sudheer and Stefanescu, Catalina and Turnbull, Stuart M., Modeling Expected Loss with Unobservable Heterogeneity (March 15, 2006). Available at SSRN: https://ssrn.com/abstract=891670 or http://dx.doi.org/10.2139/ssrn.891670

Sudheer Chava (Contact Author)

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://www.prism.gatech.edu/~schava6/

Catalina Stefanescu

ESMT European School of Management and Technology ( email )

Schlossplatz 1
10117 Berlin
Germany

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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