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Comparison of modeling methods for Loss Given Default

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  • Qi, Min
  • Zhao, Xinlei

Abstract

We compare six modeling methods for Loss Given Default (LGD). We find that non-parametric methods (regression tree and neural network) perform better than parametric methods both in and out of sample when over-fitting is properly controlled. Among the parametric methods, fractional response regression has a slight edge over OLS regression. Performance of the transformation methods (inverse Gaussian and beta transformation) is very sensitive to [epsilon], a small adjustment made to LGDs of 0 or 1 prior to transformation. Model fit is poor when [epsilon] is too small or too large, although the fitted LGDs have strong bi-modal distribution with very small [epsilon]. Therefore, models that produce strong bi-model pattern do not necessarily have good model fit and accurate LGD predictions. Even with an optimal [epsilon], the performance of the transformation methods can only match that of the OLS.

Suggested Citation

  • Qi, Min & Zhao, Xinlei, 2011. "Comparison of modeling methods for Loss Given Default," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2842-2855, November.
    • Handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2842-2855
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