Forecasting Credit Portfolio Risk
AbstractThe main challenge of forecasting credit default risk in loan portfolios is forecasting the default probabilities and the default correlations. We derive a Merton-style threshold-value model for the default probability which treats the asset value of a firm as unknown and uses a factor model instead. In addition, we demonstrate how default correlations can be easily modeled. The empirical analysis is based on a large data set of German firms provided by Deutsche Bundesbank. We find that the inclusion of variables which are correlated with the business cycle improves the forecasts of default probabilities. Asset and default correlations depend on the factors used to model default probabilities. The better the point-in-time calibration of the estimated default probabilities, the smaller the estimated correlations. Thus, correlations and default probabilities should always be estimated simultaneously. --
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Bibliographic InfoPaper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 2: Banking and Financial Studies with number 2004,01.
Date of creation: 2004
Date of revision:
asset correlation; bank regulation; Basel II; credit risk; default correlation; default probability; logit model; probit model;
Find related papers by JEL classification:
- C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
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