TITLE:
A 2-Factor Model for Inclusion of Voluntary Termination Risk in Automotive Retail Loan Portfolios
AUTHORS:
Simone Caenazzo, Ksenia Ponomareva, Mark Pain, Rob Wareing, Jameel Shivji
KEYWORDS:
Counterparty Credit Risk, Voluntary Termination
JOURNAL NAME:
Journal of Mathematical Finance,
Vol.13 No.3,
August
24,
2023
ABSTRACT: Under the UK Consumer Act 1974, obligors of Hire Purchase and Conditional Sale contracts are allowed to perform a Voluntary Termination (VT) once certain conditions are met. Upon such an event, lenders recover the underlying assets but are potentially liable to losses upon liquidation of the assets. This poses a challenge from a risk modelling perspective, as these financial products exhibit Credit (default) risk as well as VT risk, and these two events are mutually exclusive. In this paper, we propose a modelling framework to account for Credit/Default and VT risk for Retail portfolios, designed as a 2-factor Monte Carlo simulation of loan-level termination events. The paper concludes with numerical and backtesting results from a real-life implementation of such framework in the context of an automotive loan portfolio.