Abstract
This paper tries to build a joint credit risk model for PD and LGD and apply it to listed companies in Taiwan as a portfolio. PDs are allowed to depend on expected stock returns, which represent the systematic factor, as well as return thresholds based on risk ratings. LGDs are assumed to depend on asset values and equity/debt ratios, in which asset values are decomposed into three components with different ”guarantee powers” while equity/debt ratios are also assumed to be affected by the systematic factor. The key idea of this joint model is that PD and LGD are both affected by the systematic factor and therefore correlated. We find from our simulation results that the VaR is larger than it would be with fixed LGD and that LGD correlations among corporate obligators as well as LGD heterogeneity have substantial influence over VaR. The main conclusion therefore is that credit risk can be seriously underestimated by neglecting the correlation between PD and LGD.