A Two Factor Model for PD and LGD Correlation
The paper proposes a two systematic factor model to capture a retail portfolio probability of default (PD) and loss given default (LGD) parameters, in particular their mutual correlation. We argue that the standard one factor models standing behind the Basel II formula and used by a number of studies cannot capture well the correlation between PD and LGD on a large (asymptotic) portfolio. The proposed model is implemented on real banking data giving an estimate of a positive PD and LGD correlation implied by the model slightly above 10%.
Volume (Year): 18 (2011)
Issue (Month): 28 ()
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