Validating Default Probabilities on Short Time Series

by Stefan Blochwitz of Deutsche Bundesbank,
Stefan Hohl of the Bank for International Settlements,
Dirk Tasche of Deutsche Bundesbank, and
Carsten Wehn of Deutsche Bundesbank

May 7, 2004

Abstract: We present two approaches to examine the accuracy of default probability forecasts for different rating grades. In particular, we analyze the respective advantages and disadvantages of the two methods. Also, the effect of independence assumptions is taken into account by modelling latent variables like the asset correlation and dependency in time. Both tests, the Extended Traffic Light Approach as well as an ad hoc normal test work on time-varying default probability forecasts. They are considered with respect to their practical use and potential application in validating default forecasts in credit institutions.

JEL Classification: C13, C14.

Keywords: Basel II, Internal Ratings Based Approach, Validation, Default Probabilities.

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