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A Rank Estimator Approach to Modeling Default Frequencies

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  • Antti J. Harju

    (Solveva EOOD, 31 Alexander Malinov Blvd, 1729 Sofia, Bulgaria)

Abstract

This study introduces a non-parametric methodology for estimating expected frequencies of defaults and other credit events. The methodology allows for an independent estimation of a credit-quality variable, referred to as a default rank variable. In a subsequent step, the relationship between the rank variable and the expected default frequency is established. This analysis can be achieved by initially determining the functional dependence between the rank variable and the expected tail default frequencies representing the average default frequencies of entities ranked lower than a given rank value. The expected default frequency can then be derived from a simple linear integral equation. We propose a prototype model for public corporations which establishes generalized logistic function dependencies between the distance-to-default rank variable and the expected default frequencies in the log–log space. This relationship applies to public corporations across different credit rating categories.

Suggested Citation

  • Antti J. Harju, 2023. "A Rank Estimator Approach to Modeling Default Frequencies," JRFM, MDPI, vol. 16(10), pages 1-17, October.
    • Handle: RePEc:gam:jjrfmx:v:16:y:2023:i:10:p:444-:d:1260309
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    References listed on IDEAS

    as
    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Douglas, Rohan & Berndt, Antje & Duffie, Darrell & Ferguson, Mark, 2017. "Corporate Credit Risk Premia," Research Papers repec:ecl:stabus:3617, Stanford University, Graduate School of Business.
    3. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," The Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
    4. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, 2018. "Corporate Credit Risk Premia [Fallen angels and price pressure]," Review of Finance, European Finance Association, vol. 22(2), pages 419-454.
    5. Jessen, Cathrine & Lando, David, 2015. "Robustness of distance-to-default," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 493-505.
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