A Theory of Credit Rating Criteria

54 Pages Posted: 1 Jan 2020 Last revised: 7 Dec 2021

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 (AMSS)

Ruodu Wang

University of Waterloo - Department of Statistics and Actuarial Science

Date Written: December 6, 2021

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 and structural maximization, from investors who rely on the rating criterion for pricing. While the expected loss criterion used by Moody's satisfies self-consistency, the probability of default criterion used by S\&P does not. Empirical evidences in the post-Dodd-Frank period are consistent with the theoretical implication. We show that a set of axioms based on self-consistency leads a tractable representation for all self-consistent rating criteria, which can also be extended to incorporate economic scenarios. New examples of self-consistent and scenario-based rating criteria are suggested.

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, A Theory of Credit Rating Criteria (December 6, 2021). 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 (AMSS) ( email )

Ruodu Wang (Contact Author)

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

Waterloo, Ontario N2L 3G1
Canada

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