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Default probability estimation in small samples - with an application to sovereign bonds

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  • Orth, Walter
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    Abstract

    In small samples and especially in the case of small true default probabilities, standard approaches to credit default probability estimation have certain drawbacks. Most importantly, standard estimators tend to underestimate the true default probability which is of course an undesirable property from the perspective of prudent risk management. As an alternative, we present an empirical Bayes approach to default probability estimation and apply the estimator to a comprehensive sample of Standard & Poor's rated sovereign bonds. We further investigate the properties of a standard estimator and the empirical Bayes estimator by means of a simulation study. We show that the empirical Bayes estimator is more conservative and more precise under realistic data generating processes.

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    File URL: http://mpra.ub.uni-muenchen.de/33778/
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    File URL: http://mpra.ub.uni-muenchen.de/36557/
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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 33778.

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    Date of creation: 28 Sep 2011
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    Handle: RePEc:pra:mprapa:33778

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    Keywords: Low-default portfolios; empirical Bayes; sovereign default risk; Basel II;

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    1. Hanson, Samuel & Schuermann, Til, 2006. "Confidence intervals for probabilities of default," Journal of Banking & Finance, Elsevier, Elsevier, vol. 30(8), pages 2281-2301, August.
    2. Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, Elsevier, vol. 26(2-3), pages 423-444, March.
    3. Elena Kalotychou & Ana-Maria Fuertes, 2006. "On Sovereign Credit Migration: A Study of Alternative Estimators and Rating Dynamics," Computing in Economics and Finance 2006, Society for Computational Economics 509, Society for Computational Economics.
    4. Altman, Edward I, 1989. " Measuring Corporate Bond Mortality and Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 44(4), pages 909-22, September.
    5. Kiefer, Nicholas M., 2010. "Default Estimation and Expert Information," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 28(2), pages 320-328.
    6. Kiefer, Nicholas M., 2006. "Default Estimation for Low-Default Portfolios," Working Papers, Cornell University, Center for Analytic Economics 06-08, Cornell University, Center for Analytic Economics.
    7. Christensen, Jens H.E. & Hansen, Ernst & Lando, David, 2004. "Confidence sets for continuous-time rating transition probabilities," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(11), pages 2575-2602, November.
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