Credit Rating Dynamics and Markov Mixture Models

Wharton Financial Institutions Center Working Paper No. 04-15

25 Pages Posted: 1 Oct 2004

See all articles by Halina Frydman

Halina Frydman

New York University (NYU) - Department of Information, Operations, and Management Sciences

Til Schuermann

Oliver Wyman

Multiple version iconThere are 3 versions of this paper

Date Written: 2004

Abstract

Credit migration matrices are cardinal inputs to many risk management applications; their accurate estimation is therefore critical. We explore two approaches: cohort and two variants of duration - one imposing, the other relaxing time homogeneity - and the resulting differences, both statistically through matrix norms and economically using a credit portfolio model. We propose a new metric for comparing these matrices based on singular values and apply it to credit rating histories of S&P rated U.S. firms from 1981-2002. We show that the migration matrices have been increasing in "size" since the mid-1990s, with 2002 being the "largest" in the sense of being the most dynamic. We develop a testing procedure using bootstrap techniques to assess statistically the differences between migration matrices as represented by our metric. We demonstrate that it can matter substantially which estimation method is chosen: economic credit risk capital differences implied by different estimation techniques can be as large as differences between economic regimes, recession vs. expansion. Ignoring the efficiency gain inherent in the duration methods by using the cohort method instead is more damaging than imposing a (possibly false) assumption of time homogeneity.

Keywords: Risk management, credit risk, credit derivatives

JEL Classification: C13, C41, G12, G20

Suggested Citation

Frydman, Halina and Schuermann, Til, Credit Rating Dynamics and Markov Mixture Models (2004). Wharton Financial Institutions Center Working Paper No. 04-15. Available at SSRN: https://ssrn.com/abstract=597881 or http://dx.doi.org/10.2139/ssrn.597881

Halina Frydman

New York University (NYU) - Department of Information, Operations, and Management Sciences ( email )

44 West Fourth Street
New York, NY 10012
United States
212-998-0453 (Phone)

Til Schuermann (Contact Author)

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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