Nothing to do with airlines, we speak here of validating expected loss against actual loss.
A point made by Bruce M in recent comments is that there needs to be consistency in the modelling methodology behind the suite of models for the risk components PD, EAD and LGD. One task that should bring this point to the fore is the validation of EL against AL.
The PD (and EAD) models can be easily validated because their predicted outcomes become certain after 12 months. LGD is hard because
- the observation period starts later: if an account defaults in the 11th month of the 12-month outcome window, observation of the actual LGD outcome (i.e. actual loss) can only begin at that point, which is already 11 months later than the sample cohort.
- the observation period may be long
- ideally one needs to wait for the longest AL to resolve, but one can’t know in advance how long this will be
This means that ELs can only be reliably validated against ALs if the sample cohorts are quite far back in time – perhaps 2-3 years depending on product.
Nevertheless an adequate job can be done on more recent cohorts, considering that even on recent cohorts, at least some of the ALs will be known. I recommend a graphic approach showing EL vs AL for many quarterly cohorts simultaneously, with certain ALs in a bold colour, and as-yet-unresolved defaults shown on a possible – probable – worst case basis via suitable graphic clues (e.g. colours, hatching, error bars). Such a display will show a ‘fan’ effect, whereby older cohorts have a more certain EL-AL reconciliation, whereas for more recent cohorts the zone for AL fans out. (EL is a historic fact and is always known exactly)
Carrying out an EL-AL validation is a good way to review the consistency of model approaches and to detect those situations that fall betwe