THE SELECTION OF THE DISCOUNT RATE IN ESTIMATING LOSS GIVEN DEFAULT

Loss Given Default (henceforth the LGD) is the ratio of losses to exposure at default. It includes the loss of principal, the carrying costs of non-performing loans and workout expenses. In light of the management and regulatory advances regarding LGD, this paper addresses the topic of choosing the proper rate to estimate the current value of recoveries. By means of a review of the available literature on LGD, the impacts of different solutions for the discount rate (contractual rate, risk-free rate and single-factor approaches) on the variability of LGD are analyzed and compared. In order to understand the influence of market constraints from both the static and dynamic standpoints, the paper studies the methodologies for the selection of the discount rate. Considering the limitations of the approaches found in both academic and operational literature, the paper proposes a multi-factor model to measure the discount rate based on systemic and specific factors. These factors, in light of the aggregate empirical evidence, can serve as explanations for the variability of LGD.