Random LGD adjustments in the Vasicek credit risk model

Rubén García-Céspedes and Manuel Moreno

The European Journal of Finance, 2020, vol. 26, issue 18, 1856-1875

Abstract: This paper proposes an approximate formula to measure the credit risk of portfolios under random recoveries. This formula is based on a Taylor expansion and enables having recoveries that are correlated with the default rates over the business cycle. We show how to calibrate the corresponding models and the accuracy of the approximation using defaulted corporate bonds data for the period 1982–2014. Our results show that the proposed formula can be used to approximate the loss distribution of a portfolio under random correlated recoveries in a very satisfactory way. Moreover, this kind of recovery models could be easily implemented under the Basel capital requirements regulation to improve the credit risk measurement.

Date: 2020
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DOI: 10.1080/1351847X.2020.1789685

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