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Forecasting Credit Portfolio Risk

  • Hamerle, Alfred
  • Liebig, Thilo
  • Scheule, Harald

The 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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File URL: http://econstor.eu/bitstream/10419/19728/1/200401dkp_b.pdf
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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 2: Banking and Financial Studies with number 2004,01.

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Date of creation: 2004
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Handle: RePEc:zbw:bubdp2:2227
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  1. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119, March.
  2. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  3. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  4. Shumway, Tyler, 2001. "Forecasting Bankruptcy More Accurately: A Simple Hazard Model," The Journal of Business, University of Chicago Press, vol. 74(1), pages 101-24, January.
  5. 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 449-70, May.
  6. Dietsch, Michel & Petey, Joel, 2002. "The credit risk in SME loans portfolios: Modeling issues, pricing, and capital requirements," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 303-322, March.
  7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  8. Zhou, Chunsheng, 2001. "An Analysis of Default Correlations and Multiple Defaults," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 555-76.
  9. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November.
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