Probability of default estimation and validation within the context of the credit cycle

Oliver Blümke

Abstract

ABSTRACT

The dependency of the individual default behavior of a firm on the state of the credit cycle is widely implemented in credit portfolio models and ultimately reflected in the Basel II one-factor model determining capital requirements. Despite this, macroeconomic variables able to represent this one factor - accounting for fluctuations in annual default rates - are not clearly identified. This paper analyzes non-parametric estimates of the credit cycle and macroeconomic variables are identified to explain systematic fluctuations in annual default rates, ie, the credit cycle. Applications of the presented methodology are in the area of default probability estimation and validation.