A Treatise of PD-LGD Correlation Modelling

The provision in Paragraph 468 of Basel II Framework Document for calculating loss given default (LGD) requires that parameters used in Pillar I of Basel II capital estimations must be reflective of economic downturn conditions so that relevant risks are accounted for. This provision is based on the fact that the probability of default (PD) and LGD correlations are not captured in the proposed formula for estimating economic capital. To help quantify economic downturn LGD, the Basel Committee proposed establishing a functional relationship between long-run and downturn LGD. To the best of our knowledge, the current proposed models that map out this relationship have the same underlying framework. This thesis presents a general factor PD-LGD correlation model within the conditional independence framework, where obligors’ defaults are conditional on a common state of affairs in the economy. We highlight a mistake that is frequently made in specifying loss given default, which is, current studies ignore the difference between account-level potential loss and LGD. By correcting this mistake and deriving the correct distribution of potential loss and LGD, sensitivity analysis is conducted to ascertain the impact of the defective model on economic capital and parameter estimates. The relationship between the account and portfolio level correlations are explored. Finally, an empirical analysis is conducted to validate the proposed estimation scheme of parameters in the model.

Name thesis:degree_name

Ph D

Discipline thesis:degree_discipline

Statistics and Actuarial Sciences

Grantor dc:publisher

The University of Western Ontario

Year dc:date.issued

2020

Author dc:creator

• Avusuglo, Wisdom S

Advisors dc:contributor.advisor

• Reesor Mark R
• Metzler Adam

• PD-LGD correlation
• potential loss
• realized loss
• systematic and idiosyncratic risk factors
• economic and regulatory capital.

Language dc:language.iso

en_ca

Handle dc:identifier.uri

https://hdl.handle.net/20.500.14721/30507

OAI identifier oai:identifier

oai:uwo.scholaris.ca:20.500.14721/30507