Estimating PD and LGD for unrated small enterprises
Summary
The discussion considers how to estimate default probabilities and loss given default for small firms without traded bonds or equities, when market-implied credit measures are unavailable. It describes two balance-sheet approaches: a Merton-style structural model, which treats equity as a claim on firm assets and estimates default risk from asset value, liabilities, drift, volatility, and horizon; and regression models that relate financial indicators to default outcomes.
The responses caution that market-based PDs or LGDs generally require reference instruments with observable prices. Without those, estimates rely on company financial statements and other counterparty characteristics, or on point-in-time and stressed estimates from a credit risk team. The exchange provides methods rather than empirical results, and does not explain how to estimate asset volatility, select regression variables, or validate either approach. It also notes that accounting-purpose estimates may not meet fair-value requirements, so model choice should reflect the valuation framework.
Key ideas
- Market-implied PD and LGD require reference instruments with observable prices.
- A Merton-style model estimates default risk by comparing modeled asset value with liabilities at a chosen horizon.
- Balance-sheet indicators can serve as predictors in regression models for firms without traded securities.
- Estimates depend on available firm data and should match the applicable valuation framework.
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Full text
# How to estimate market based PD and LGD for small enterprises?
# How to estimate market based PD and LGD for small enterprises?
I am estimating CVA/DVA for derivatives...
How to estimate PD and LGD (or RR) based on market data for the small enterprises, if there is no external rating for them and they don't have bonds or equities on exchange market? Note that these are companies from small open economy, so there are also no external ratings other than for the whole country.
I am asking for literature, methods or any tips and tricks...
## Answer by TomDecimus (score 0, accepted)
https://quant.stackexchange.com/a/44022
In '74 Merton proposed a Credit Risk Model based on modelling the equity of a company as a call on its assets. Its very straight forward. You can calibrate on a single point or over a time series of the variables below.
You only need the book value of a firm's equity, E, total assets, A, total liabilities, L and the volatility of them.
$PD=1−N(DD)$
where DD,
$DD= (ln(A)+(μ_A−σ^2_A/2)T−ln(L))/(σ_A\sqrt{T})$
https://www.mathworks.com/help/risk/default-probability-using-the-merton-model-for-structural-credit-risk.html
## Answer by J. Doe. (score 0)
https://quant.stackexchange.com/a/44136
Unless there are reference instruments you can back out the implied PD or implied LGD you cannot find market-based pds and lgds for small companies. To my knowledge the only way to calculate the PD and LGDs for these smaller corporates / enterprises is to build models based on balance sheet information, or other characteristics you have for the counterparties.
You might work in a bank or similar - ask your credit risk modelling team to provide you with the point in time PDs and stressed LGDs for your list of companies.
## Answer by Vesnič (score 0)
https://quant.stackexchange.com/a/44181
I need to follow IFRS13 so I cannot use PDs and LGDs calculated for IFRS9...
As above noted I will use balance sheet data, but there are more than one options to do it:
- using Merton-like default models
- using regression analysis that use financial indicators as independent variable.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.