Goodness-of-Fit of Logistic Regression of the Default Rate on GDP Growth Rate and on CDX Indices

Kuang-Hua Hu, Shih-Kuei Lin, Yung-Kang Ching and Ming-Chin Hung
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Kuang-Hua Hu: Finance and Accounting Research Center, School of Accounting, Nanfang College, Guangzhou 510970, China
Shih-Kuei Lin: Department of Money and Banking, National Chengchi University, Taipei 116, Taiwan
Yung-Kang Ching: Risk Management Department, China Development Financial Holding, Taipei 105, Taiwan
Ming-Chin Hung: Department of Financial Engineering and Actuarial Mathematics, Soochow University, Taipei 100, Taiwan

Mathematics, 2021, vol. 9, issue 16, 1-14

Abstract: Under the Basel II and Basel III agreements, the probability of default (PD) is a key parameter used in calculating expected credit loss (ECL), which is typically defined as: PD × Loss Given Default × Exposure at Default. In practice or in regulatory requirements, gross domestic product (GDP) has been adopted in the PD estimation model. Due to the problem of excessive fluctuation and highly volatile ECL estimation, models that produce satisfactory PD and thus ECL estimations in the context of existing risk management techniques are lacking. In this study, we explore the usage of the credit default swap index (CDX), a market’s expectation of future PD, as a predictor of the default rate (DR). By comparing the goodness-of-fit of logistic regression, several conclusions are drawn. Firstly, in general, GDP has considerable explanatory power for the default rate which is consistent with current models in practice. Secondly, although both GDP and CDX fit the DR well for rating B class, CDX has a significantly better fit of DR for ratings [A, Baa, Ba]. Thirdly, compared with low-rated companies, the relationship between the DR and GDP is relatively weak for rating A. This phenomenon implies that, in addition to using macroeconomic variables and firm-specific explanatory variables in the PD estimation model, high-rated companies exhibit a greater need to use market supplemental information, such as CDX, to capture the changes in the DR.

Keywords: credit default swap index; expected credit loss; GDP; goodness-of-fit; probability of default; risk measures (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2021
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