A Short Note on Transfer Risk

Transfer risk can be an important risk factor for the estimation of a borrower's default risk, and thus has to be included into the PD estimations for the IRB approach under Basel II. In practice, there are two main methodologies for capturing transfer risk: the direct inclusion in the borrower rating system (the country being one of the risk factors, and the country rating often effectively serving as a cap on the rating scale) or the separation of quot;idiosyncratic borrower default riskquot; (i.e. borrower default risk ex transfer events) and quot;transfer riskquot; into two separate rating systems and two separate PDs. We derive correct PDs that include both borrower and transfer risk and propose a simple methodology to implement the two PDs approach