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John Clayburn is trying to parameterize a credit risk model for his employer, Syacmoor Bank. Based on a large sample of loans, he has estimated a default frequency of 12%. John knows that this is a necessary input to calculate the unexpected loss. Which of the following is closest to the standard deviation of Sycamoor’s default frequency?
A. 88%.
B. 12%.
C. 11%.
D. 35%.
Answer:D
The standard default model assumes a two-state (binary) default process. Therefore, the variance = EDF × (1 ? EDF) = (0.12) × (1 ? 0.12) = 0.1056. Thus, standard deviation of default frequency (0.1056)0.5 = 0.32496.
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