Multiperiod default probability forecasting

Abstract

Accounting standards require that financial institutions must measure default risk with respect to the full maturity of a financial instrument. This requires forecasting of future default probabilities. The forecast of future default probabilities concerns two aspects: forecasting macroeconomic scenarios and future average (with respect to the macroeconomy) default probabilities. The present paper addresses the modeling of future average default probabilities. For corporations and depending on the initial rating grade, default probabilities change in different patterns over time. For initial investment‐grade ratings, the risk of a default increases, whereas for the bottom of the rating scale, default probabilities decrease. To model these different patterns, the paper proposes to extend the existing discrete‐time survival model and to incorporate an additional time‐ and covariate‐dependent shape parameter into the hazard function. Using data from Standard & Poor's, the paper shows that the shape parameter is able to reproduce the different patterns. The proposed model is benchmarked against a model that does not employ a shape parameter, and the results show that the additional shape parameter improves in‐sample and out‐of‐sample prediction.