Witzany, Jiří, "Estimating LGD Correlation", IUP Journal of Financial Risk Management, Vol. 52, No. 4, (December 2010), pp. 73-83.

Abstract: The paper proposes a new method to estimate correlation of account level Basle II Loss Given Default (LGD). The correlation determines the probability distribution of portfolio level LGD in the context of a copula model which is used to stress the LGD parameter as well as to estimate the LGD discount rate and other parameters. Given historical LGD observations we apply the maximum likelihood method to estimate the best correlation parameter. The method is applied and analyzed on a real large data set of unsecured retail account level LGDs and the corresponding monthly series of the average LGDs. The correlation estimate comes relatively close to the PD regulatory correlation. It is also tested for stability using the bootstrapping method and used in an efficient formula to estimate ex ante one-year stressed LGD, i.e. one-year LGD quantiles on any reasonable probability level.

JEL Classification: G21, G28, C14.

Keywords: credit risk, recovery rate, loss given default, correlation, regulatory capital.

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