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The Vasicek Distribution

Dirk Tasche
Lloyds TSB Bank
Corporate Markets Rating Systems
dirk.tasche@gmx.net

Bristol / London, August 2008

Theopinions expressed in this presentation are those of the author and do not
necessarily reflect views of Lloyds TSB Bank.
i
Outline

What is special about the Vasicek distribution? (slide 1)

Properties of the Vasicek distribution (slide 8)

Modelling default rates (slide 17)

Related topics (not covered) (slide 30)

ii
What is special about the Vasicek distribution? (1)

The Vasicek distribution is a two-parametric (0 < p < 1,


0 < % < 1) continuous distribution on (0, 1) with density
r 
1% 1% 1
(x)1 (p) 2
 n  o
1 1 2
fp,%(x) = % exp 2 (x) % . (1.1)

Other two-parametric continuous distributions on (0, 1) include

the beta-distribution with parameters , > 0 and density


(+) 1 1 ,
f, (x) = () ()
x (1 x)

the Kumaraswamy distribution with parameters a, b > 0 and


density
fa,b(x) = a b xa1 (1 xa)b1.

1
What is special about the Vasicek distribution? (2)

Examples of densities

3.0
Mean 0.25 , Stddev 0.137

2.5

2.0
Density value

Vasicek
Beta
1.5 Kumaraswamy

1.0

0.5

0.0
0% 25% 50% 75% 100%
Loss percentage

2
What is special about the Vasicek distribution? (3)

Examples of densities

5 Mean 0.25 , Stddev 0.354

4
Density value

3 Vasicek
Beta
Kumaraswamy
2

0
0% 25% 50% 75% 100%
Loss percentage

3
What is special about the Vasicek distribution? (4)

Observations:

When fitted to the same mean and standard deviation, the Va-
sicek, beta, and Kumaraswamy densities do not differ much.

Vasicek: Density looks sophisticated, moment matching of cor-


relation parameter % requires numerical root-finding.

Kumaraswamy: Density looks simple, but moment matching


requires numerical solution of two-dimensional optimisation prob-
lem.

beta: Density looks relatively simple, moment matching is easy.

Why not just working with the beta distribution?

4
What is special about the Vasicek distribution? (5)

Kumaraswamy: Similar to beta but more efficient for simulation.

beta: http://en.wikipedia.org/wiki/Beta distribution

Appears naturally as distribution of order statistics:


X1, . . . , Xn i.i.d. uniformly distributed,
X[k] = minI{1,...,n}, |I|=k max{Xi : i I} (k-th smallest)

X[k] (k, n k + 1),


(n)
Z x
(5.1)
i.e. P[X[k] x] = (k) (nk+1) uk1 (1 u)nk du.
0
Dirichlet distribution is multi-variate extension of beta distribu-
tion.
However, there is no economic motivation of the beta distri-
bution.

5
What is special about the Vasicek distribution? (6)

Its the economy, stupid

Vasicek distribution can be interpreted in context of a trigger


mechanism that is useful for modeling credit risk.

Denote by A the change in value of an obligors assets in a fixed


time period (say 1 year).

Denote by t the default threshold.

The obligors default is triggered if A t.

Then P D = P[A t] is the unconditional probability of default.

6
What is special about the Vasicek distribution? (7)

Oldrich Vasicek (1987):



Assume that A = % S + 1 % where S is the systematic
and the idiosyncratic risk factor. S and are independent and
standard normal.
Consider the conditional (on the systematic factor) probability
of default P D(S):
 t% S 
P D(S) = P[A t | S] = 1% (7.1)

Then P D(S) is a Vasicek-distributed random variable with


p = (t).

Probabilityof Loss on Loan Portfolio,


http://www.moodyskmv.com/research/portfolioCreditRisk wp.html
2
denotes the standard normal distribution function: (x) = eu /2 du.
R
2

7
Properties of the Vasicek distribution (1)

Important observation: If X has a Vasicek distribution with pa-


rameters p and %, then by Slide 7 X can be represented as
 t% S 
X = 1% , (8.1)

where t = 1(p) and S is a standard normal random variable.

Consequences:
 1
1%
(x)t

Distribution function: Fp,%(x) = P[X x] = %

Density: fp,%(x) = x Fp,%(x) (see (1.1))


 t+% 1() 
1 () =
Quantiles: Fp,%
1%

8
Properties of the Vasicek distribution (2)

Moments

Let n be a positive integer and 1, . . . , n i.i.d. standard normal. If X is


Vasicek-distributed with parameters p = (t) and %, then
h  t% S ni
n
E[X ] = E 1%
hYn p i
= E i=1
P[ % S + 1 % i t | S]
h p p i
= E P[ % S + 1 % 1 t, . . . , %S + 1 % n t | S]
p p
= P[ % S + 1 % 1 t, . . . , % S + 1 % n t]

= P[Y1 t, . . . , Yn t], (9.1)


where (Y1, . . . , Yn) is a multi-variate normal vector with E[Yi] = 0,
var[Yi] = 1, and corr[Yi, Yj ] = %, i 6= j.

9
Properties of the Vasicek distribution (3)

Special cases:
E[X] = P[Y t] = p
(10.1)
var[X] = E[X 2] E[X]2 = P[Y1 t, Y2 t] p2

Define 2(s, t; %) = P[Y1 s, Y2 t], where (Y1, Y2) is a bivariate


normal vector with E[Yi] = 0, var[Yi] = 1, and corr[Y1, Y2] = %.

Estimating p and % from a sample x1, . . . , xm (0, 1) by moment-


matching:
m
1
 p = m
P
xi
i=1

m
1
 % is unique solution of 2(t, t; %) = m
P
x2
i
i=1

10
Properties of the Vasicek distribution (4)

Indirect moment matching

Observation: If X is Vasicek-distributed with parameters p and %,


then Y = 1(X) is normally distributed with
1 (p) %
E[Y ] = =
1%
, var[Y ] = 2 = 1% (11.1)

Estimate and by
m m
1 X 1
1(xi), 2 = 1(xi)2 2
X
= (11.2)
m i=1 m i=1

Solve then (11.1) for p and %:





2
p = , % = 1+2 (11.3)
1+ 2

(p, %) is also the maximum likelihood estimator of (p, %).

11
Properties of the Vasicek distribution (5)

Quantile-based estimators

Use again observation (11.1) on the transformation of the sample


into a normally distributed sample.

Choose probabilities 0 < 1 < 2 < 1 and calculate the empirical


quantiles q(1) < q(2) of the transformed sample.

Determine estimators and from the equations


q(i) = + 1(i), i = 1, 2 (12.1)

Determine estimator p of p and % of % by solving (11.3) for p and


%.

12
Properties of the Vasicek distribution (6)

Simulation study of estimation efficiency

Simulate 1000 times a Vasicek sample of length 5, 10, 25, and


100, for parameter values p = 0.1 and % = 0.25.

Compare results for

direct moment matching (DMM)


indirect moment matching (= maximum likelihood estimation,
MLE)
quantile-based estimation (QBE)

Tabulate estimators (Est.), standard deviations (SD) of estimators,


and standard errors (SE).

13
Properties of the Vasicek distribution (7)

Results for estimation of p

Sample size 5 10
Est. p SD SE Est. p SD SE
DMM 0.1017 0.0455 0.0455 0.1000 0.0312 0.0312
MLE 0.1009 0.0446 0.0446 0.0996 0.0308 0.0308
QBE 0.1220 0.0603 0.0642 0.1012 0.0399 0.0399

Sample size 25 100


Est. p SD SE Est. p SD SE
DMM 0.1004 0.0191 0.0191 0.1000 0.0099 0.0099
MLE 0.1002 0.0189 0.0189 0.0999 0.0098 0.0098
QBE 0.1005 0.0257 0.0257 0.1003 0.0133 0.0133

14
Properties of the Vasicek distribution (8)

Results for estimation of %

Sample size 5 10
Est. % SD SE Est. % SD SE
DMM 0.2091 0.1306 0.1368 0.2242 0.1004 0.1036
MLE 0.1972 0.1071 0.1194 0.2223 0.0785 0.0832
QBE 0.2964 0.2025 0.2076 0.2081 0.1469 0.1526

Sample size 25 100


Est. % SD SE Est. % SD SE
DMM 0.2393 0.0714 0.0722 0.2461 0.0376 0.0378
MLE 0.2385 0.0514 0.0527 0.2468 0.0271 0.0272
QBE 0.2308 0.1052 0.1069 0.2459 0.0569 0.0570

15
Properties of the Vasicek distribution (9)
Comments on the simulation study

Estimation of p:

Little difference between Direct Moment Matching (DMM) and


Maximum Likelihood Estimation (MLE). Quantile-Based Esti-
mation (QBE) is clearly less efficient (higher Standard Error).
All estimators seem nearly unbiased (i.e. the mean of many
estimates is close to the true value) for sample size 10 or greater.

Estimation of %:

MLE is most efficient (as expected from statistical theory),


DMM is second, QBE is worst.
None of the estimators is unbiased. In average, they all underes-
timate the correlation parameter, even for relatively large sample
size 100.

16
Modelling default rates (1)

Future default rates of a portfolio cannot be predicted with cer-


tainty.

Based on appropriate probabilistic models, however, probabilities


of interesting future events can be calculated (e.g. the probability
to observe a default rate of more than 1%).

Models should be able to explain clustering of defaults (i.e. very


high observed rates in some years, very low rates in other years).

Common approach: create default correlation by dependence on


one or more systematic factors.

17
Modelling default rates (2)
Binomial approach

n independent borrowers

Default event: Di = {Borrower i defaults}


1, if Di occurs
Default indicator: 1Di =
0, otherwise

Identical default probability: P D = P[Di] = P[1Di = 1]

n
1 X
Default rate: DR = 1D
n i=1 i

18
Modelling default rates (3)

Calculating the default rate distribution

Exact binomial probability by incomplete beta integrals:


k !
k n
 
P D` (1 P D)n`
X
P DR =
n `
`=0
R1 k
u (1 u)nk1 du (19.1)
= PD
R1
uk (1 u)nk1 du
0
h i  
Normal approximation: k
P DR n kn P D
n P D (1P D)

k
h
k
i
n P D
X (n P D)`
Poisson approximation: P DR n e
`=0
`!
19
Modelling default rates (4)

Comments on binomial calculations

On principle, there is no reason to use approximations for binomial


distributions.

Calculations are fast (even in MSExcel) when the incomplete beta


representation is used.

For PDs up to 10% the Poisson approximation is better than the


normal approximation.

The Poisson approximation is useful for algebraic calculations with


default or loss rates (actuarial approach, CreditRisk+).

20
Modelling default rates (5)
General observations on the binomial approach

1 P D (1 P D)
E[DR] = P D, var[DR] = n

Hence lim var[DR] = 0


n

Conclusion: If default events were independent, for large pools of


borrowers with similar credit-worthiness the variation of observed
default rates over time would be small.

Contradiction to empirically observed credit cycles.

Problem: Independence of default events


P[Borrowers i and j default] = P[Di Dj ] = P D2 (21.1)

21
Modelling default rates (6)
Vasicek approach: correlated binomial distribution

Choose representation of default event Di such that defaults be-


come dependent (cf. Slide 7):
p
Di = { % S + 1 % i t} (22.1)

S is the systematic factor, i is the idiosyncratic factor,


and t = 1(P D).

S and i, i = 1, . . . , n, are independent and standard normal.

Consequence: Defaults are no longer independent:


P[Borrowers i and j default] = P[Di Dj ] = 2(t, t; %) > P D2
(22.2)

22
Modelling default rates (7)
Observations on the Vasicek approach

1 P D P D 2 + n1 (t, t; %)
E[DR] = P D, var[DR] = n n 2

Hence lim var[DR] = 2(t, t; %) P D2 > 0


n

Conclusion: The Vasicek approach can depict cyclic variation of


default rates even for very large portfolios.

Expectation given systematic factor (from (7.1)) is


Vasicek-distributed:
 t% S 
E[DR | S] = 1% (23.1)

Large portfolio behaviour (approximation by E[DR | S]):


h i  
2 1
lim E (DR E[DR | S]) = lim n P D 2(t, t; %) = 0 (23.2)
n n
23
Modelling default rates (8)

Binomial and correlated binomial distributions


0.12

PD = 0.1, rho = 0.12, n = 100


0.08
Frequency
0.04

Binomial
Corr Binomial
0.00

0.0 0.1 0.2 0.3 0.4 0.5


Default rate

24
Modelling default rates (9)

Vasicek and correlated binomial distributions


8
6

PD = 0.1, rho = 0.12, n = 100


Frequency * n
4

Corr binomial
Vasicek
2
0

0.0 0.1 0.2 0.3 0.4 0.5


Default rate

25
Modelling default rates (10)

Vasicek and correlated binomial distributions


8
6
Frequency * n

PD = 0.1, rho = 0.12, n = 250


4

Corr binomial
2

Vasicek
0

0.0 0.1 0.2 0.3 0.4 0.5


Default rate

26
Modelling default rates (11)
Vasicek approach: Calculating the default rate distribution

Exact probability by conditioning and integrating against density


of systematic factor:
k k
    
P DR = E P DR S
n n
Z k !
 t% s `  t% s n`
n
X 
= (s) 1% 1 1% ds
`
`=0
(27.1)

Alternative: by Monte-Carlo simulation (less accurate).

Density of E[DR | S]: by (1.1).


2
s /2
denotes the standard normal density function: (s) = e ds.
2
27
Modelling default rates (12)
Vasicek (2002)

Fit the distribution of DR (correlated binomial) by a Vasicek-


distributed variable X with parameters p = P D and % such that
2(t, t; %) P D2 = var[X]
1 P D P D 2 + n1 (t, t; %) (28.1)
= var[DR] = n n 2

Involves numerical root-finding and calculation of bivariate normal


distribution.

Kolmogorov-Smirnov distances for fitting correlated binomial dis-


tribution: (exact distribution by (27.1))

Approximation by Vasicek-distribution with P D, %: 0.078


Approximation by Vasicek-distribution with P D, %: 0.048
The distribution of loan portfolio value, RISK 15, 160-162
28
Modelling default rates (13)

Vasicekfit and correlated binomial distributions


8
6

PD = 0.1, rho = 0.12, rho* = 0.143, n = 100


Frequency * n
4

Corr binomial
Vasicekfit
2

Vasicek
0

0.0 0.1 0.2 0.3 0.4 0.5


Default rate

29
Related topics (not covered)

Default rate modelling with negative binomial (conditional Poisson)


distributions.

Across-time default rate modelling.

Multi-factor models.

Portfolio-loss models (heterogeneity of exposures).

Derivation of Basel II risk weight functions.

...

30

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