Uncovering PD/LGD liaisons
Francisco Sanchez, Roland Ordovas, Elena Martinez and Manuel Vega consider the presence of correlation between default and recovery through the familiar variance of loss formula. Business cycle dependence permits a neat decomposition of the variance expression and helps clarify how PD/LGD correlation effects affect capital measures. A practical expression is given to quantify the PD/LGD interaction both at an individual and portfolio level
Understanding dependencies between the probability of default (PD) and loss given default (LGD) through their variation over time, based on the different phases of the economic cycle, is crucial to quantifying their impact on the calculation of credit risk capital. From a technical point of view, the assumption of two different models for PDs and LGDs, when there is a non-trivial correlation between the two, leads to biased estimates for the PD and LGD parameters, which if not considered could
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