The Impact Of Discount Rate Choice In Estimating The Workout LGD

Abstract

<p>The workout approach to estimating the loss given default compares the actual value of the recovery flows with the exposure at default to measure the efficacy of the recovery process. One of the main problems related to this approach is the selection of the proper discount rate for evaluating the portfolio. In the literature, there are different solutions proposed, but there is no evidence on the impact of the choice of one of these alternatives on the LGD measurement. This paper looks at a proprietary database for the timeframe 1985-2005, evaluates the impact of the discount rate on the LGD value and studies the main determinants of LGDs computed using different approaches. Even if the explanatory variables are the same, LGDs defined using different discount rates show differences in the percentile distribution that could significantly affect the capital requirements of a financial intermediary.</p>

Benchmarking loss given default discount rates

“…The choice of discount rates has a low to moderate impact, which is a function of the average resolution time, which decreases from 3.16 in 2000 to 0.51 in 2013, and the average equity risk premium: the price for systematic risk increases from 2.19 in 2000 to 6.84% in 2013. These findings are in line with those of Gibilaro and Mattarocci (2011), who analyze the impact of the risk-free rate, contract rate and two equilibrium models (based on the beta between average recoveries and GDP as well as average recoveries and a defaulted bond index). The average LGDs vary between 0.5051 (using a risk-free discount rate) and 0.5327 (using the equilibrium model based on the defaulted bond index).…”