Default and recovery correlations - a dynamic econometric approach

In credit risk models, the loss given default (LGD)1 is either incorporated deterministically (as in Credit Risk+) or stochastically (as in CreditMetrics). In the latter case, the LGD may be drawn from a beta distribution.2 In both cases, no correlation between default and LGD is considered.

In economic downturns, not only do probabilities of default (PDs) increase, but recovery rates also decrease. This pattern can be seen in historical data (see, for example, Frye, 2000, or Altman et al, 2003)

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