Journal of Risk

An internal default risk model: simulation of default times and recovery rates within the new Fundamental Review of the Trading Book framework

Andrea Bertagna, Dragos Deliu, Luca Lopez, Aldo Nassigh, Michele Pioppi, Fabian Reffel, Peter Schaller and Robert Schulze

In January 2016, the Basel Committee on Banking Supervision published its new requirements for the calculation of market risk within the banking sector. These requirements go under the name of the Fundamental Review of the Trading Book. The default risk model is one part of these requirements that is subject to material changes: recovery rates must be stochastic variables, basis risk due to differences in recoveries have to be considered, and a dependence between recovery rates and systematic risk factors used to simulate default times must be enforced. This paper presents a new default risk model for market risk that is consistent with these requirements. The recovery rates follow a waterfall model that is based on a minimum entropy principle. Moreover, the model features correlation between default times and stochastic recovery rates by exploiting the observed correlation between default frequency and average recoveries in historical data. As well as giving some mathematical background, the authors present the numerical results and the impacts of the various model parameters. These show that the introduced correlation can have a significant impact on the capital charge.

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