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The Two-Parameter Formula of Default Probability Term Structure

Pomazanov M.V. National Research University Higher School of Economics, Moscow, Russian Federation ( m.pomazanov@hse.ru )

Journal: Digest Finance, #4, 2018

Subject The article discusses the existing methods to model the term structure of default probability and their drawbacks affecting the practical use.
Objectives The research is aimed to make effective suggestions to creditors on setting the technique to evaluate the probability of the corporate borrower's default, considering a changeable term before the loan deal ends, without contradicting IFRS 9 – Financial Instruments.
Methods The research represents the economic and statistical analysis, optimizes aspects of special distributions based on statistical data of rating agencies.
Results I refer to consolidated empirical data of rating agencies on the corporate sector to substantiate the two-parameter formula of term structure of default probability, which does not contradict IFRS 9 with respect to corporate borrowers. In this case, internal bank data are insufficient to build the separate internal model PD Lifetime or this process is too arduous.
Conclusions and Relevance I substantiate the default probability term structure formula, which is best in the pool of fitting distributions, being calibrated with empirically and statistically representative external data of rating agencies, covering a 44-year period. The formula is explicit, without implying complex calculations. The formula may prove useful in calculating the rate of reserves for loan assets, with their terms being coordinated with the principle lending mechanism (SPPI test) with respect to the second impairment phase under the classification given in IFRS 9.


A two-parameter formula of default probability term structure

Pomazanov M.V. National Research University Higher School of Economics, Moscow, Russian Federation ( m.pomazanov@hse.ru )

Journal: Finance and Credit, #8, 2018

Importance This paper describes the existing methods of default probability term structure modeling and the disadvantages that limit their application.
Objectives The paper aims to give an effective offer to lenders on the construction of a method of estimating the probability of default of a corporate borrower, taking into account the changed term to the end of the credit transaction, not contradicting the new IFRS 9 standard.
Methods For the study, I used an economic and statistical analysis, and optimization of parameters of special kind of distributions on statistical data of rating agencies.
Results Using the consolidated empirical data of rating agencies, I attribute a two-parameter formula of default probability term structure, which does not contradict the requirements of the international standard IFRS 9 for the corporate borrowers sector, that does not have enough internal data to build its own Lifetime PD internal model.
Conclusions and Relevance The presented study substantiates the formula of calculation of a default probability term structure in the best fitting distribution pool. It is calibrated on external empirical and statistical data of rating agencies, including a 44-year period. The formula is explicit and does not require complex computations. The results obtained can be used to calculate the rate of reserves for credit assets, estimate the minimum (break-even) lending rate taking into account the risk and the term of the transaction, optimize the term of the transaction, and for other possible applications.


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