Expected Loss Over Lifetime

([SHFWHG/RVV2YHU/LIHWLPH
Professor Daniel Roesch

University of Regensburg
15 March 2016
The views expressed in the following material are the
author’s and do not necessarily represent the views of
the Global Association of Risk Professionals (GARP),
its Membership or its Management.
2
Expected Loss Over Lifetime
Steffen Krüger, Toni Oehme, Daniel Rösch, Harald

Scheule
Chair of Statistics and Risk Management, Faculty of Business, Economics

and Management Information Systems
Universität Regensburg
Finance Discipline Group, University of Technology

Sydney
March 15, 2016

Contents
1. Motivation
2. Methods
3. Data and Estimation Results
4. Expected Loss Over Lifetime Results
5. Conclusion
Expected Loss Over Lifetime | Daniel Rösch | UR / UTS Sydney March 15, 2016 2 / 34
Motivation
Agenda
1. Motivation
2. Methods
5. Conclusion
Motivation
Credit loss
• Credit loss is determined by
L = D · LR · EAD (1)
where
D: Default indicator (1, if default, 0, else)

LR : Loss rate
EAD : Exposure at default
• Here: EAD = 1
Motivation
Expected credit loss
• Expected credit loss is given by
E(L) = E(D) · E(LR) + Cov(D, LR)

= E(D) · E(LR|D = 1) (2)
= E(D) · E(LGD) (3)
where LGD is the loss (rate) given default.
→ What role does the link between default risk and LGD play?
Motivation
Regulatory Requirements
• BCBS (2005)
• Downturn LGD:: ”[...] reflect economic downturn conditions where
necessary to capture the relevant risks.”
• ”Under such conditions default rates are expected to be high so that if
recovery rates are negatively related to default rates, LGD parameters
must embed forecasts of future recovery rates that are lower than
those expected during more neutral conditions.”
• BCBS (2009)
• ”[...] there is need to cover substantially longer periods [...] as liquidity
conditions can change rapidly in stressed conditions.”
• ”The bank should [...] assess the impact of recession-type scenarios,
including its ability to react over a medium to long time horizon.”
• IASB (2014): Impairment in IFRS 9 Financial Instruments
• Lifetime expected credit losses: ”The expected credit losses that result
from all possible default events over the expected life of a financial
instrument.”
Motivation
IASB (2014)
Impairment in IFRS 9 Financial Instruments
Stage Impairment requirement Impairment recognition

1 Origination / purchase 12-month expected credit losses
2 Significantly increased credit risk Lifetime expected credit losses
3 Credit-impaired Lifetime expected credit losses
• Introduction of concept of Lifetime expected credit losses (LEL)
→ Time-dependence of LGD estimates?
Motivation
Illustration of LGD Term Structure
Motivation
Literature on PD and LGD odels
• Default risk
• PD models
• Altman (1968), Merton (1974), Gordy (2000), and Campbell et al. (2008)
• Survival analysis
• Lee and Urrutia (1996), Shumway (2001), Duffie et al. (2007) and Duffie
et al. (2009)
• Loss given default

• Carey (1998), Pykhtin (2003), Qi and Yang (2009), Huang and Oosterlee
(2012) and Jankowitsch et al. (2014)
→ No actual dependence investigated
Motivation
Literature on PD/LGD Dependence Modeling

The link between default risk and losses given default
• LGDs are positively correlated with default rates

• Frye (2000), Altman et al. (2005) and Acharya et al. (2007)
• ’Jointly’ modeling of default and LGD component
• Chava et al. (2011), Bellotti and Crook (2012), Frye and Jacobs Jr
(2012)
• Ignoring dependence and sample selection results in biased
parameter estimates
• Rösch and Scheule (2014)
→ Need for further research
Motivation
This Paper: Two Important Issues and

Extensions
1. ”Classical” PD and LGD models are separate modules:

• A PD model and a stand-alone LGD model
• However: LGD can only be observed conditional on a default
• This imposes a sample selection mechanism
• As known from early work (eg. Tobin, 1958), this creates inconsistent
LGD estimates, if PD and LGD are correlated and if this not properly
addressed
2. ”Classical” PD models are one-periodic (eg. have a one-year
forecasting horizon)
• Need to model multi-year/lifetime defaults and the term structure of
LGDs over the lifetime
• As well as interaction (correlation) between default and LGD term
structure
Motivation
Contributions
• We propose a model for expected loss over lifetime (LEL) which

takes into account
• Dependence between time-to-default and LGD via Copulas
• Sample selection
• Derive term structures for PDs and LGDs
• Empirical strategy for estimation
• Estimation and LEL forecasting results for real-world data
Methods
Agenda
1. Motivation
2. Methods
5. Conclusion
Methods
Expected Loss over Lifetime

• ELoL
( )
LEL = E 1{T ≤m} · LGDT · b(T ) , (4)
where m denotes the maturity and b(T ) a discount factor

• This is equivalent to
∫m ∫1
LEL = fLGDT ,T (l, t) · l · b(t) dl dt (5)
0 0
• Dependence between default time (PD) and LGD is taken into

account in two ways:
• Deterministic: using joint covariates
• Stochastic: using copulas
• Sample selection is addressed by adjusting the Likelihood
Methods
The Full Model and its Constituents I
• Maximum likelihood estimation

• Likelihood:
∏ ∏
L(βT , σ, βµ , ϕ, θ) = ( 1 − FTi (ti ) ) f(Ti ,Yi ) (ti , yi ) (6)
i:Di =0 i:Di =1
| {z }
πit
where
( )
πit = c FTi (ti ), FYi (yi ) · fTi (ti ) · fYi (yi ) (7)
• PD: Survival (AFT) Model (T , βT , σ )
log Ti = βT′ xTi + σεi , (8)
• LGD: Beta Regression (Y , βµ , ϕ)
Methods
The Full Model and its Constituents II
• Let the LGD be described by the beta distributed random variable Y:
1
fY (y) = y α−1 (1 − y)β−1 , (9)
B(α, β)
with parameters α, β > 0 and beta function B : (0, ∞)2 → R2

• Ferrari and Cribari-Neto (2004)
α
µ= and ϕ = α + β. (10)
α+β
1
µi = . (11)
1 + exp(−βµ′ xµ
i)
• Copula (θ) with density c(·, ·)
Methods
Introduction to Copulas
Theorem (Special case of Sklar (1959))

Let X and Y be univariate continuous random variables with cumulative
distribution functions FX , FY and joint distibution function F(X,Y ) .
Then there exists a unique function C : [0, 1]2 → [0, 1] with
F(X,Y ) (x, y) = C(FX (x), FY (y)) = C(u, v), u, v ∈ [0, 1], (12)
where C is called copula.
Example (Gaussian copula)
C(u, v) = Φ2 (Φ−1 (u), Φ−1 (v); ρ), u, v ∈ [0, 1], ρ ∈ [−1, 1]. (13)
Methods
Properties of Analysed Copulas
Generator Parameter
Copula Cθ (u, v), u, v ∈ [0, 1] φθ (t) space for θ
uv 1 − θ(1 − t)
AMH log [−1, 1)
1 − θ(1 − u)(1 − v) t
−1
Clayton (u−θ + v −θ − 1) θ 1 (t−θ − 1) (−∞, 0) ∪ (0, ∞)
θ
( −θu −θv
) −θt
(e − 1)(e − 1) −1
Frank − 1 log 1+ −θ − log e −θ−1 (−∞, ∞)
θ (e − 1) e
Gaussian Φ2 (Φ−1 (u), Φ−1 (v); θ) - [−1, 1]

( ( )1 )
Gumbel exp − (− log(u))θ + (− log(v)) θ θ
(− log(t))θ [1, ∞)
( )1
Joe 1 − (1 − u)θ + (1 − v)θ − (1 − u)θ (1 − v) θ θ
− log(1 − (1 − t)θ ) [1, ∞)
Product uv − log(t) -
Student’s t t2 (t−1 (u), t−1 (v); θ) - [−1, 1]
Methods
Scatterplot of various copulas
{
0, if Product copula,
• Rank correlation coefficient Kendall’s τ =
0.3, else.
Data and Estimation Results
Agenda
1. Motivation
2. Methods
5. Conclusion
Data
• Moody’s Default & Recovery Database (DRD)
• Default and recovery data
• Lifetime US-corporate bond data with long-term rating
• 1982 - 2014
• 48,828 observations (2,455 defaults)
• Control variables
• Bond-specific (rating, seniority, maturity, face amount, coupon)
• Issuer-specific (excess return, market-to-book-ratio,
net-income-to-total-assets, market-cap., liabilities-to-total-assets
industry)
data
• Macro-economic (industry production, term spread, downturn and
vintage effects)
400
300
Frequency
200
100
0.0 0.2 0.4 0.6 0.8 1.0
Expected Loss Over Lifetime | Daniel Rösch LGD | UR / UTS Sydney March 15, 2016 21 / 34
Default Rates and Mean LGDs
Models for Time to Default
Models for LGD
Copula Results
Expected Loss Over Lifetime Results
Agenda
1. Motivation
2. Methods
5. Conclusion
Analysis of Specific Risk Buckets
LGD Densities (Term Structures)
Term Structures for PD and LGD
Model Differences
LEL Predictions for Industrial Bonds
Conclusion
Agenda
1. Motivation
2. Methods
5. Conclusion
Conclusion
Summary
• Link between time-to-default and LGD

• Provide general model for Expected Loss over Lifetime
• Derive term structures for PDs, LGDs, and ELoL
• Negative dependence between time-to-default and LGD after
controlling for covariates
→ Ignoring dependence results in

• Biased parameter estimates
• Underestimation of risk
References
References I
Acharya, V. V., Bharath, S. T., Srinivasan, A., (2007). Does industry-wide distress affect de-
faulted firms? Evidence from creditor recoveries. Journal of Financial Economics
85 (3), 787–821.
Altman, E. I., (1968). Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy. The Journal of Finance 23 (4), 589–609.
Altman, E. I., Brady, B., Resti, A., Sironi, A., (2005). The Link between Default and Recov-
ery Rates: Theory, Empirical Evidence, and Implications. Journal of Business 78 (6),
2203–2228.
BCBS, (2005). Guidance on Paragraph 468 of the Framework Document. Bank for Interna-
tional Settlements, Basel.
BCBS, (2009). Principles for sound stress testing practices and supervision. Bank for Interna-
tional Settlements, Basel.
Bellotti, T., Crook, J., (Jan. 2012). Loss given default models incorporating macroeconomic
variables for credit cards. International Journal of Forecasting 28 (1), 171–182.
Campbell, J. Y., Hilscher, J., Szilagyi, J., (2008). In search of distress risk. The Journal of Fi-
nance 63 (6), 2899–2939.
Carey, M., (1998). Credit risk in private debt portfolios. The Journal of Finance 53 (4), 1363–
1387.
References
References II
Chava, S., Stefanescu, C., Turnbull, S., (2011). Modeling the Loss Distribution. Management
Science 57 (7), 1267–1287.
Duffie, D., Eckner, A., Horel, G., Saita, L., (2009). Frailty correlated default. The Journal of
Finance 64 (5), 2089–2123.
Duffie, D., Saita, L., Wang, K., (2007). Multi-period corporate default prediction with
stochastic covariates. Journal of Financial Economics 83 (3), 635–665.
Ferrari, S., Cribari-Neto, F., (2004). Beta regression for modelling rates and proportions.
Journal of Applied Statistics 31 (7), 799–815.
Frye, J., (2000). Depressing recoveries. Risk 13 (11), 108–111.
Frye, J., Jacobs Jr, M., (2012). Credit loss and systematic loss given default. Journal of Credit
Risk 8 (1), 1–32.
Gordy, M. B., (2000). A comparative anatomy of credit risk models. Journal of Banking &
Finance 24 (1), 119–149.
Heckman, J. J., (1979). Sample selection bias as a specification error. Econometrica, 153–
161.
Huang, X., Oosterlee, C. W., (2012). Generalized beta regression models for random loss-
given-default. The Journal of Credit Risk 7 (4), 45–70.
IASB, (2014). IFRS 9 Financial Instruments.
References
References III
Jankowitsch, R., Nagler, F., Subrahmanyam, M. G., (2014). The determinants of recovery
rates in the US corporate bond market. Journal of Financial Economics 114 (1), 155–
177.
Lee, S. H., Urrutia, J. L., (1996). Analysis and prediction of insolvency in the property-liability
insurance industry: A comparison of logit and hazard models. Journal of Risk and
Insurance, 121–130.
Merton, R. C., (1974). On the Pricing of Corporate Debt: The Risk Structure of Interest
Rates. The Journal of Finance 29 (2), 449–470.
Pykhtin, M., (2003). Unexpected recovery risk. Risk 16 (8), 74–78.
Qi, M., Yang, X., (2009). Loss given default of high loan-to-value residential mortgages.
Journal of Banking & Finance 33 (5), 788–799.
Rösch, D., Scheule, H., (2014). Forecasting probabilities of default and loss rates given de-
fault in the presence of selection. Journal of the Operational Research Society 65 (3),
393–407.
Shumway, T., (2001). Forecasting Bankruptcy More Accurately: A Simple Hazard Model. The
Journal of Business 74 (1), 101–124.
Sklar, M., (1959). Fonctions de répartition à n dimensions et leurs marges. Université Paris
8.
Tobin, J., (1958). Estimation of relationships for limited dependent variables. Econometrica
26 (1), 24–36.
C r e a t i n g a c u l t u r e o f
r i s k a w a r e n e s s ®
Global Association of
Risk Professionals
111 Town Square Place

14th Floor
Jersey City, New Jersey 07310
U.S.A.
+ 1 201.719.7210
2nd Floor
Bengal Wing
9A Devonshire Square
London, EC2M 4YN
U.K.
+ 44 (0) 20 7397 9630
www.garp.org
About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make
better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies,
academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®)
Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for
professionals of all levels. www.garp.org.
4 | © 2014 Global Association of Risk Professionals. All rights reserved.

Expected Loss Over Lifetime

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Expected Loss Over Lifetime

Încărcat de

Drepturi de autor:

Formate disponibile

([SHFWHG/RVV2YHU/LIHWLPH

Professor Daniel Roesch

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

Steffen Krüger, Toni Oehme, Daniel Rösch, Harald

Chair of Statistics and Risk Management, Faculty of Business, Economics

Finance Discipline Group, University of Technology

March 15, 2016

3. Data and Estimation Results

4. Expected Loss Over Lifetime Results

3. Data and Estimation Results

4. Expected Loss Over Lifetime Results

• Credit loss is determined by

D: Default indicator (1, if default, 0, else)

Expected credit loss

• Expected credit loss is given by

E(L) = E(D) · E(LR) + Cov(D, LR)

where LGD is the loss (rate) given default.

Stage Impairment requirement Impairment recognition

• Introduction of concept of Lifetime expected credit losses (LEL)

→ Time-dependence of LGD estimates?

Illustration of LGD Term Structure

Literature on PD and LGD odels

• Loss given default

→ No actual dependence investigated

Literature on PD/LGD Dependence Modeling

• LGDs are positively correlated with default rates

→ Need for further research

This Paper: Two Important Issues and

1. ”Classical” PD and LGD models are separate modules:

• We propose a model for expected loss over lifetime (LEL) which

• Derive term structures for PDs and LGDs

• Empirical strategy for estimation

• Estimation and LEL forecasting results for real-world data

3. Data and Estimation Results

4. Expected Loss Over Lifetime Results

Expected Loss over Lifetime

where m denotes the maturity and b(T ) a discount factor

• Dependence between default time (PD) and LGD is taken into

• Sample selection is addressed by adjusting the Likelihood

The Full Model and its Constituents I

• Maximum likelihood estimation

• PD: Survival (AFT) Model (T , βT , σ )

log Ti = βT′ xTi + σεi , (8)

• LGD: Beta Regression (Y , βµ , ϕ)

The Full Model and its Constituents II

• Let the LGD be described by the beta distributed random variable Y:

with parameters α, β > 0 and beta function B : (0, ∞)2 → R2

• Copula (θ) with density c(·, ·)

Theorem (Special case of Sklar (1959))

Then there exists a unique function C : [0, 1]2 → [0, 1] with

where C is called copula.

Example (Gaussian copula)

Properties of Analysed Copulas

Gaussian Φ2 (Φ−1 (u), Φ−1 (v); θ) - [−1, 1]

Student’s t t2 (t−1 (u), t−1 (v); θ) - [−1, 1]

Scatterplot of various copulas

3. Data and Estimation Results

4. Expected Loss Over Lifetime Results

0.0 0.2 0.4 0.6 0.8 1.0

Default Rates and Mean LGDs

Models for Time to Default

Models for LGD