Journal of Credit Risk

Correlation between default events and loss given default and downturn loss given default in Basel II

Zailong Wan, Ashish Dev


We derive analytically the effects of PD-LGD correlation on portfolio credit VaR and economic capital with a structural form model and show that under certain assumptions, an approximate linear relationship between downturn loss given default and expected loss given default exists. Thus we provide a model-theoretic justification of the formula in the US Basel II NPR (2006) that relates downturn loss given default to expected loss given default, a formula that has become rather controversial in the implementation of Basel II in the US.

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