The credit rating process and estimation of transition probabilities: a Bayesian approach

Stefanescu, Catalina, Tunaru, Radu and Turnbull, Stuart (2009) The credit rating process and estimation of transition probabilities: a Bayesian approach. Journal of Empirical Finance, 16 (2). pp. 216-234. ISSN 0927-5398

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Abstract

The Basel II Accord requires banks to establish rigorous statistical procedures for the estimation and validation of default and ratings transition probabilities. This raises great technical challenges when sufficient default data are not available, as is the case for low default portfolios. We develop a new model that describes the typical internal credit rating process used by banks. The model captures patterns of obligor heterogeneity and ratings migration dependence through unobserved systematic macroeconomic shocks. We describe a Bayesian hierarchical framework for model calibration from historical rating transition data, and show how the predictive performance of the model can be assessed, even with sparse event data. Finally, we analyze a rating transition data set from Standard and Poor's during 1981–2007. Our results have implications for the current Basel II policy debate on the magnitude of default probabilities assigned to low risk assets.

Item Type: Article
Keywords: Ratings transitions; Bayesian inference; Latent factors; Markov Chain Monte Carlo
Schools and Departments: University of Sussex Business School > Accounting and Finance
Research Centres and Groups: Quantitative International Finance Network
Subjects: H Social Sciences > HG Finance > HG0101 Theory. Method. Relation to other subjects
H Social Sciences > HG Finance > HG0101 Theory. Method. Relation to other subjects > HG0106 Mathematical models
H Social Sciences > HG Finance > HG3691 Credit. Debt. Loans
Depositing User: Radu Tunaru
Date Deposited: 23 Jan 2020 12:24
Last Modified: 23 Jan 2020 12:24
URI: http://sro.sussex.ac.uk/id/eprint/89500
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