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Stress Testing of Probability of Default of Individuals

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    Abstract

    This paper introduces a model for stress testing of probability of default of individuals. The model rests on assumption that the individual defaults if his savings fall below zero. The probability of default is then described as a function of several macroeconomic indicators such as wages, unemployment and interest rates. Stress testing is carried out by applying exogenous stress scenarios for development of these indicators. The model implies that sensitivity of probability of default to the stress is mainly driven by Installment to Income Ratio and for mortgages also by loan maturity. Hence Installment to Income ratio is suggested as the appropriate tool to manage credit risk of retail portfolios.

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    File URL: http://ies.fsv.cuni.cz/default/file/download/id/8777
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    Bibliographic Info

    Paper provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its series Working Papers IES with number 2008/11.

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    Length: 17 pages
    Date of creation: Jul 2008
    Date of revision: Jul 2008
    Handle: RePEc:fau:wpaper:wp2008_11

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    Keywords: banking; credit risk; stress testing; probability of default;

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    1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
    3. Petr JAKUBÍK, 2007. "Macroeconomic Environment and Credit Risk (in English)," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 57(1-2), pages 60-78, March.
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