The selection of the discount rate in estimating the Loss Given Default

The Loss Given Default (henceforth the LGD) is the ratio of losses to exposure at default and 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 the LGD, this paper takes on the topic of choosing the proper rate for the estimate of the current value of recoveries. By means of a review of the available literature on LGD, the impacts of different solution for the discount rate (contractual rate, risk-free rate and single-factor approaches) on the variability of LGD are analyzed ad compared. In order to understand the influence of market constraints from both the static and dynamic standpoints the paper studies in depth the purposes and the methodologies for the selection of the discount rate in accounting and prudential standards. Considering the limitations of the approaches found in both academic and operational literature to the measurement of the discount rate, the paper proposes a multi-factor model based on systemic and specific factors that, in light of the aggregate empirical evidence, can serve as explanations for the variability of the LGD.