Credit Risk and LGD Modelling

This paper deals with the methods for estimating credit risk parameters from market prices, e.g. Probability of Default (PD) and Loss Given Default (LGD). Precise evaluation of these parameters is important not only for bank to calculate their regulatory capital but also for investors to price risky bonds and credit derivatives. In this paper, we introduced reduced-form analytical methods for the calculation of LGD to pricing Credit Default Swaps. Reduced-form credit risk models were introduced as a reaction to structural approach, especially trying to decrease informational difficulty when modelling credit risk. In the reduced-form approach, the market value of defaulted bonds is the same as in the fraction recovered from the exposure at default. We use the face value convention, which Hull & White (2000) presented in their model which extended recovery of face value convention for coupon bonds.