Downturn LGD: A spot recovery approach

by Hui Li of AIG

January 18, 2010

Abstract: Basel II suggests that banks estimate downturn loss given default (DLGD) in capital requirement calculation. There have been studies that model the dependence between default rates and losses given default through economic cycles. However, the models proposed are still not satisfactory due to the direct specification of term loss given default. In this paper, we propose a new model framework based on our recent work of stochastic spot recovery for Gaussian copula. We discuss the large homogeneous pool (LHP) limit and derive analytic formula for VaR and expected shortfall in the case of a single systematic factor. We also compare numerically the downturn LGD in our model with those of the previous approaches.

JEL Classification: G13, G32.

Keywords: Basel II, Downturn Loss Given Default, Stochastic Recovery, Spot Recovery, Factor Credit Models, Default Time Copula, Gaussian Copula, Large Homogeneous Pool, Credit VaR, Expected Shortfall.

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