The Implementation of a Rating-Risk Based Credit Risk Model

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