IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Empirical Implementation of a 2-Factor Structural Model for Loss-Given-Default

Registered author(s):

    In this study we develop a theoretical model for ultimate loss-given default in the Merton (1974) structural credit risk model framework, deriving compound option formulae to model differential seniority of instruments, and incorporating an optimal foreclosure threshold. We consider an extension that allows for an independent recovery rate process, representing undiversifiable recovery risk, having a stochastic drift. The comparative statics of this model are analyzed and compared and in the empirical exercise, we calibrate the models to observed LGDs on bonds and loans having both trading prices at default and at resolution of default, utilizing an extensive sample of losses on defaulted firms (Moody’s Ultimate Recovery Database™), 800 defaults in the period 1987-2008 that are largely representative of the U.S. large corporate loss experience, for which we have the complete capital structures and can track the recoveries on all instruments from the time of default to the time of resolution. We find that parameter estimates vary significantly across recovery segments, that the estimated volatilities of recovery rates and of their drifts are increasing in seniority (bank loans versus bonds). We also find that the component of total recovery volatility attributable to the LGD-side (as opposed to the PD-side) systematic factor is greater for higher ranked instruments and that more senior instruments have lower default risk, higher recovery rate return and volatility, as well as greater correlation between PD and LGD. Analyzing the implications of our model for the quantification of downturn LGD, we find the ratio of the later to ELGD (the “LGD markup”) to be declining in expected LGD, but uniformly higher for lower ranked instruments or for higher PD-LGD correlation. Finally, we validate the model in an out-of-sample bootstrap exercise, comparing it to a high-dimensional regression model and to a non-parametric benchmark based upon the same data, where we find our model to compare favorably. We conclude that our model is worthy of consideration to risk managers, as well as supervisors concerned with advanced IRB under the Basel II capital accord.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL: http://www.michaeljacobsjr.com/Jacobs_LGDModel_JFT_3-11_31_31-43
    File Function: Full text
    Download Restriction: no

    Article provided by Capco Institute in its journal Journal of Financial Transformation.

    Volume (Year): 31 (2011)
    Issue (Month): ()
    Pages: 31-43

    as
    in new window

    Handle: RePEc:ris:jofitr:1455
    Contact details of provider: Postal: 120 Broadway, 29th Floor New York, NY 10271
    Phone: +1 212 284 8600
    Web page: http://www.capco.com/
    Email:

    No references listed on IDEAS
    You can help add them by filling out this form.

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:ris:jofitr:1455. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Peter Springett)

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.