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Dynamic Multi-Factor Credit Risk Model with Fat-Tailed Factors

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Abstract

The authors introduce an improved multi-factor credit risk model describing simultaneously the default rate and the loss given default. Their methodology is based on the KMV model, which they generalize in three ways. First, they add a model for loss given default (LGD), second, they bring dynamics to the model, and third, they allow non-normal distributions of risk factors. Both the defaults and the LGD are driven by a common factor and an individual factor; the individual factors are mutually independent, but the authors allow any form of dependence of the common factors. They test their model on a nationwide portfolio of US mortgage delinquencies, modeling the dependence of the common factor by a VECM model, and compare their results with the current regulatory framework, which is described in the Basel II Accord.

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Bibliographic Info

Article provided by Charles University Prague, Faculty of Social Sciences in its journal Finance a uver - Czech Journal of Economics and Finance.

Volume (Year): 62 (2012)
Issue (Month): 2 (May)
Pages: 125-140

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Handle: RePEc:fau:fauart:v:62:y:2012:i:2:p:125-140

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Keywords: credit risk; probability of default; loss given default; credit loss; credit loss distribution; Basel II;

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  1. Andrea Cipollini & Giuseppe Missaglia, 2008. "Measuring bank capital requirements through Dynamic Factor analysis," Center for Economic Research (RECent) 010, University of Modena and Reggio E., Dept. of Economics.
  2. Quigley, John M., 2002. "Real Estate Prices and Economic Cycles," Berkeley Program on Housing and Urban Policy, Working Paper Series qt58c6v2kx, Berkeley Program on Housing and Urban Policy.
  3. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
  4. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January.
  5. Billio, Monica & Getmansky, Mila & Lo, Andrew W. & Pelizzon, Loriana, 2012. "Econometric measures of connectedness and systemic risk in the finance and insurance sectors," Journal of Financial Economics, Elsevier, vol. 104(3), pages 535-559.
  6. Jon Frye, 2000. "Collateral damage detected," Emerging Issues, Federal Reserve Bank of Chicago, issue Sep.
  7. Jiri Witzany, 2011. "A Two Factor Model for PD and LGD Correlation," Bulletin of the Czech Econometric Society, The Czech Econometric Society, vol. 18(28).
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