The Implementation of a Rating-Risk Based Credit Risk Model

41 Pages Posted: 4 Jun 2003

See all articles by Meng-Lan Yueh

Meng-Lan Yueh

National Chengchi University

Nick Webber

University of Warwick - Warwick Business School

Abstract

The credit risk model developed by Hamilton, James and Webber introduces the firm-specific information into the rating transition process through a measure of credit quality of the underlying firm. In this paper, we present an algorithm, for constructing a three-dimensional lattice to implement their model. In addition to the time space dimension, the proposal lattice has the credit quality of the underlying firm and the rating class in the other two dimensions. Therefore, the rating transition behavior can be specified in one lattice framework. By considering the probabilities of default and being rerated at each node, the lattice framework. By considering the probabilities of default and being related at each node, the lattice produces a branching process with seven branches emanating from each node. We use the proposed lattice method to examine the impact of the credit quality and the rating class on the value of a defaultable bond. After being calibrated to market spread data, the lattice is used to price credit derivatives.

Keywords: rating-based credit risk models, model implementation, three-dimensional lattice

Suggested Citation

Yueh, Meng-Lan and Webber, Nick, The Implementation of a Rating-Risk Based Credit Risk Model. Available at SSRN: https://ssrn.com/abstract=392603 or http://dx.doi.org/10.2139/ssrn.392603

Meng-Lan Yueh (Contact Author)

National Chengchi University ( email )

No. 64, Sec. 2, ZhiNan Road
Wenshan District
Taipei, Taiwan 11605
Taiwan

Nick Webber

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom
+(44) 24 7652 4664 (Phone)

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