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Copula-Based Factor Model for Credit Risk Analysis

Meng-Jou Lu, Cathy Yi-Hsuan Chen, Karl Wolfgang Härdle and Härdle

No SFB649DP2015-042, SFB 649 Discussion Papers from Humboldt University, Collaborative Research Center 649

Abstract: A standard quantitative method to access credit risk employs a factor model based on joint multi- variate normal distribution properties. By extending a one-factor Gaussian copula model to make a more accurate default forecast, this paper proposes to incorporate a state-dependent recovery rate into the con- ditional factor loading, and model them by sharing a unique common factor. The common factor governs the default rate and recovery rate simultaneously and creates their association implicitly. In accordance with Basel III, this paper shows that the tendency of default is more governed by systematic risk rather than idiosyncratic risk during a hectic period. Among the models considered, the one with random fac- tor loading and a state-dependent recovery rate turns out to be the most superior on the default prediction.

Keywords: Factor Model; Conditional Factor Loading; State-Dependent Recovery Rate (search for similar items in EconPapers)
JEL-codes: C38 C53 F34 G11 G17 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm, nep-for, nep-ger and nep-rmg
Date: 2015-08
References: View references in EconPapers View complete reference list from CitEc
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