Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/257808 
Authors: 
Year of Publication: 
2021
Citation: 
[Journal:] International Journal of Financial Studies [ISSN:] 2227-7072 [Volume:] 9 [Issue:] 4 [Article No.:] 63 [Publisher:] MDPI [Place:] Basel [Year:] 2021 [Pages:] 1-22
Publisher: 
MDPI, Basel
Abstract: 
In this study, we consider the construction of through-the-cycle ("TTC") PD models designed for credit underwriting uses and point-in-time ("PIT") PD models suitable for early warning uses, considering which validation elements should be emphasized in each case. We build PD models using a long history of large corporate firms sourced from Moody's, with a large number of financial, equity market and macroeconomic variables as candidate explanatory variables. We construct a Merton model-style distance-to-default ("DTD") measure and build hybrid structural reduced-form models to compare with the financial ratio and macroeconomic variable-only models. In the hybrid models, the financial and macroeconomic explanatory variables still enter significantly and improve the predictive accuracy of the TTC models, which generally lag behind the PIT models in that performance measure. We conclude that care must be taken to judiciously choose the manner in which we validate TTC vs. PIT models, as criteria may be rather different and be apart from standards such as discriminatory power. This study contributes to the literature by providing expert guidance to credit risk modeling, model validation and supervisory practitioners in controlling the model risk associated with such modeling efforts.
Subjects: 
credit risk
credit underwriting
early warning systems
model risk
model validation
point-in-time
probability of default
regulatory capital
through-the-cycle
JEL: 
G21
G28
M40
E47
Persistent Identifier of the first edition: 
Creative Commons License: 
cc-by Logo
Document Type: 
Article

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