Decomposing Rating Migration Matrices from Market Prices Revisited

The IUP Journal of Applied Finance, Vol. 26, No. 3, July 2020, pp. 5-27

Posted: 26 Mar 2021

See all articles by Brian Barnard

Brian Barnard

University of the Witwatersrand - Wits Business School

Multiple version iconThere are 2 versions of this paper

Date Written: March 23, 2020

Abstract

The study revisits the method and premises of decomposing rating migration matrices from price data. Default and non-default probability term structures are first decomposed from market prices. This represents the composite default probability structure or process of a rating category, when considering rating migration and future ratings probabilities. A rating migration matrix is subsequently decomposed from this output. Output residuals are low, yet the optimization problem finds many local solutions, rather than a solid global solution: different rating migration matrices can result in and produce the same decomposed default probability term structures. Price data contain sufficient information to decompose the default and non-default probability term structures, but lack sufficient data to decompose the non-default probability term sub-structures. The implication is that bond prices are not dependent on future ratings, over and above non-default probability term structures (“survival rates”), as a mirror of default probability term structures, as the latter already contains all price-relevant information. At the same time, it may be unnecessary to decompose rating migration matrices, post default probability term structures.

Suggested Citation

Barnard, Brian, Decomposing Rating Migration Matrices from Market Prices Revisited (March 23, 2020). The IUP Journal of Applied Finance, Vol. 26, No. 3, July 2020, pp. 5-27, Available at SSRN: https://ssrn.com/abstract=3810539

Brian Barnard (Contact Author)

University of the Witwatersrand - Wits Business School ( email )

Johannesburg
South Africa

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