Market-Based Credit Ratings

Abstract

We present a methodology for rating the credit worthiness of public companies in the U.S. from the prices of traded assets. Our approach uses asset pricing data to impute a term structure of risk neutral survival functions or default probabilities. Firms are then clustered into ratings categories based on their survival functions using a functional clustering algorithm. This allows all public firms whose assets are traded to be directly rated by market participants. For firms whose assets are not traded, we show how they can be indirectly rated through the use of matching estimators. We also show how the resulting ratings can be used to construct loss distributions for portfolios of bonds. Our approach has the advantages of being transparent, computationally tractable, simple to implement, and easy to interpret economically.

Keywords: credit ratings, clustering, credit default swaps, default risk, survival functions

JEL Classification: C32, G32