Measuring credit risk by using a parameterized model under risk-neutral measure

Abstract

This article assesses credit risk by using a parameterized model under risk-neutral measure, elaborating the assumption of Byström and Kwon (2007) by using interpolation to estimate the risk-free yield curve. The required data are minimal; the proposed model only necessitates information regarding loans, such as loan rates, and risk-free rates that can avoid shortcomings of rating data. The default probabilities are estimated under risk-neutral measure though few studies have done so. The empirical results show that default probabilities of financial distress are higher compared to those of normal firms. Furthermore, the proposed model is also closely associated with the economic state.

Keywords:

• credit risk
• parameterized model
• risk-neutral measure
• Basel Capital Accord

JEL Classification:

• G10
• G21
• G33

Notes

¹ The six industries include Foods, Plastics, Textiles, Electric. Machinery, Iron and Steel and Electronics.

² The data are derived from the Council for Economic Planning and Development (CEPD) in Taiwan. The CEPD is responsible for drafting overall plans for national economic development, evaluating development projects, coordinating economic policymaking activities of ministries and agencies and monitoring the implementation of development projects, measures and programmes.

³ The IDM database seeks to quantify all factors that are sought by a risk manager, to enable risk-based making. The IDM database establishes models for predicting financial distress comprising three variables: financial variables, corporate governance and macroeconomic variables. The database estimates the firms' IDM scores by above variables and logistic model. If the IDM scores lower than the critical value, the firm will be a normal firm (nondistressed firm). If the IDM scores higher than the critical value, the firm will be a distressed firm.