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Modeling the Loss Distribution

Author

Listed:
  • Sudheer Chava

    () (College of Management, Georgia Institute of Technology, Atlanta, Georgia 30308)

  • Catalina Stefanescu

    () (ESMT European School of Management and Technology, 10178 Berlin, Germany)

  • Stuart Turnbull

    () (Bauer College of Business, University of Houston, Houston, Texas 77204)

Abstract

In this paper, we focus on modeling and predicting the loss distribution for credit risky assets such as bonds and loans. We model the probability of default and the recovery rate given default based on shared covariates. We develop a new class of default models that explicitly accounts for sector specific and regime dependent unobservable heterogeneity in firm characteristics. Based on the analysis of a large default and recovery data set over the horizon 1980-2008, we document that the specification of the default model has a major impact on the predicted loss distribution, whereas the specification of the recovery model is less important. In particular, we find evidence that industry factors and regime dynamics affect the performance of default models, implying that the appropriate choice of default models for loss prediction will depend on the credit cycle and on portfolio characteristics. Finally, we show that default probabilities and recovery rates predicted out of sample are negatively correlated and that the magnitude of the correlation varies with seniority class, industry, and credit cycle. This paper was accepted by Wei Xiong, finance.

Suggested Citation

  • Sudheer Chava & Catalina Stefanescu & Stuart Turnbull, 2011. "Modeling the Loss Distribution," Management Science, INFORMS, vol. 57(7), pages 1267-1287, July.
  • Handle: RePEc:inm:ormnsc:v:57:y:2011:i:7:p:1267-1287
    as

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    File URL: http://dx.doi.org/10.1287/mnsc.1110.1345
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    References listed on IDEAS

    as
    1. Darrell Duffie & Andreas Eckner & Guillaume Horel & Leandro Saita, 2009. "Frailty Correlated Default," Journal of Finance, American Finance Association, vol. 64(5), pages 2089-2123, October.
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    9. Das, Sanjiv R. & Hanouna, Paul, 2009. "Implied recovery," Journal of Economic Dynamics and Control, Elsevier, vol. 33(11), pages 1837-1857, November.
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    11. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
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    13. Sudheer Chava & Robert A. Jarrow, 2008. "Bankruptcy Prediction with Industry Effects," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 21, pages 517-549 World Scientific Publishing Co. Pte. Ltd..
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    16. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
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