Self-Consistency, Subjective Pricing, and a Theory of Credit Rating

47 Pages Posted: 1 Jan 2020 Last revised: 26 Jan 2020

See all articles by Nan Guo

Nan Guo

China Bond Rating Co. Ltd.

Steven Kou

Boston University

Bin Wang

Chinese Academy of Sciences (CAS) - Academy of Mathematics and Systems Science

Ruodu Wang

University of Waterloo - Department of Statistics and Actuarial Science

Date Written: December 14, 2019

Abstract

We propose a theory for rating financial securities based on a concept of self-consistency, which does not allow issuers to gain, by tranching financial securities, from investors who rely on the rating criterion. While the expected loss criterion used by Moody's satisfies self-consistency, the probability of default criterion used by S&P does not. We find empirical evidences in the post-Dodd-Frank period (i.e., after July 2010) that the issuers may take advantage of the absence of self-consistency. We further propose a concept of scenario-relevance which reflects practical evaluation procedures of potential losses from defaultable securities. Our main theoretical results show that a self-consistent rating measure admits a Choquet integral representation, and this representation is also analytically tractable if one further takes economic scenarios into account. We suggest new examples of self-consistent and scenario-based rating criteria, such as ones based on the VaR and the Expected Shortfall.

Keywords: Credit ratings, Structured finance, Dodd-Frank, Axiomatic characterization

JEL Classification: G12

Suggested Citation

Guo, Nan and Kou, Steven and Wang, Bin and Wang, Ruodu, Self-Consistency, Subjective Pricing, and a Theory of Credit Rating (December 14, 2019). Available at SSRN: https://ssrn.com/abstract=3504065 or http://dx.doi.org/10.2139/ssrn.3504065

Nan Guo

China Bond Rating Co. Ltd. ( email )

Steven Kou

Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
6173583318 (Phone)

Bin Wang

Chinese Academy of Sciences (CAS) - Academy of Mathematics and Systems Science ( email )

Ruodu Wang (Contact Author)

University of Waterloo - Department of Statistics and Actuarial Science ( email )

Waterloo, Ontario N2L 3G1
Canada

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