How to gauge the credit risk of guarantee issues in a Taiwanese bills finance company: an empirical investigation using a market-based approach

Abstract

This paper presents a formal methodology, using a market-based risk neutral approach, to gauge the credit risk of guarantee issues in a Taiwanese bills finance company. In particular, the probability of default is endogenously determined. Evidence shows that the recovery rate plays an important role in credit risk of a bills finance company's guarantee issues. On the other hand, credit risk is also correlated with different industries and business cycles, and care must be taken to consider these factors. Faced with the implementation of the Basel Capital Accord, it is anticipated that this paper will be helpful to Taiwan's financial institutions.

Evaluating guarantee fees for loans to small and medium-sized enterprises

“…Numerous methodologies been developed under this approach, such as those by Jonkhart (1979) Jarrow et al (1997), Duffee and Singleton (1997), and Lando (1998). Particularly, Lu and Kuo (2005) successfully applied a reduced-form model to measure credit risk of a Taiwanese bills finance corporation that provided guarantees to firms issuing commercial papers. Their study derives the PD of the corporation exogenously with market information as well as assuming a reasonable recovery rate in default cases.…”

“…In addition, SMEG is recognized as an eligible guarantor under Basel II regulations and, according to the ''Draft on standard approaches and internal rating-based approach on credit risk'' issued by the Financial Supervisory Commission of the Taiwan government in July 2005, SMEG-guaranteed SME loans are eligible for credit risk mitigation. Based on these conditions, the authors are interested in developing a credit risk evaluation model for guarantors such as SMEG by combining Lu and Kuo's (2005) model with insurance actuarial pricing theory.…”

How to Measure the Credit Risk of Housing Loans: Evidence from a Taiwanese Bank

“…Lu and Kuo (2005) used a market-based risk neutral approach to investigate credit risks associated with guaranteed issues in Taiwanese financial companies. Lu (2007) used a formal model, the conditional Markov chain model for gauging credit risk and applied it to Taiwan bank loans from 1998-2003.…”

“…The recovery rate serves as security for bank loans; it depends on liquidity and the value and specific type of collateral. Previous studies assume the recovery rate to be an exogenous recovery rate (Briys and de Varenne 1997;Carty and Lieberman 1996;Copeland and Jones 2001;Fons 1987;Longstaff and Schwartz 1995;Lu and Kuo 2005). The research presented here, however, uses an endogenous recovery rate, and the estimates are therefore more accurate.…”