Stochastic modelling of the default rates and recovery rates of a bank loan

Abstract

In this project, the assumption of risk neutral will be applied to estimate jointly the default probabilities and recovery rate of a bank loan. This is achieved by putting into consideration the practical differences between loan and bond to modify and extend Merrick's credit risk model on bonds. Based on the empirical results from a case Bank, we show that high (low) implied default recovery rate should result jointly in high (low) implied default rate. In addition, the result also shows that it should be helpful for banks to reduce the credit risk through diversified loan types. The model can provide a feasible solution for financial institutions needed to adopt internal rating-based approach under the new Basel Capital Accord.