Estimating and validating long run probability of default

The risk of default is derived by analyzing the obligor’s capacity to repay the debt in accordance with contractual terms.

PD is generally associated with financial characteristics such as inadequate cash flow to service debt, declining revenues or operating margins, high leverage, declining or marginal liquidity, and the inability to successfully implement a business plan.

PD is closely linked to the expected loss, which is defined as the product of the PD, the loss given default (LGD) and the exposure at default (EAD).

PD is the risk that the borrower will be unable or unwilling to repay its debt in full or on time.

It applies to a particular assessment horizon, usually one year.

Credit scores, such as FICO for consumers or bond ratings from S&P, Fitch or Moodys for corporations or governments, typically imply a certain probability of default.

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With these Vasicek models, asset correlation and long-run PD for a risk homogenous portfolio both have analytical solutions, longer external time series for market and macroeconomic variables can be included, and the traditional asymptotic maximum likelihood approach can be shown to be equivalent to least square regression, which greatly simplifies parameter estimation. Thus, the information available to estimate PD can be divided into two broad categories - An unstressed PD is an estimate that the obligor will default over a particular time horizon considering the current macroeconomic as well as obligor specific information.This implies that if the macroeconomic conditions deteriorate, the PD of an obligor will tend to increase while it will tend to decrease if economic conditions improve.As a first step this framework makes use of Merton approach in which leverage and volatility (or their proxies) are used to create a PD model.As a second step, this framework assumes existence of systematic factor(s) similar to Asymptotic Risk Factor Model (ASRF).

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