A Simulation Estimator for Testing the Time Homogeneity of Credit Rating Transitions

28 Pages Posted: 9 Aug 2006

See all articles by C. Erik Larson

C. Erik Larson

Promontory Financial Group

Nicholas M. Kiefer

Cornell University - Department of Economics

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The measurement of credit quality is at the heart of the models designed to assess the reserves and capital needed to support the risks of both individual credits and portfolios of credit instruments. A popular specification for credit rating transitions is the simple, time-homogeneous Markov model. While the Markov specification cannot really describe processes in the long run, it may be useful for adequately describing short-run changes in portfolio risk. In this specification, the entire stochastic process can be characterized in terms of estimated transition probabilities. However, the simple homogeneous Markovian transition framework is restrictive. We propose a test of the null hypotheses of time-homogeneity that can be performed on the sorts of data often reported. We apply the tests to 4 data sets, on commercial paper, sovereign debt, municipal bonds and S&P Corporates. The results indicate that commercial paper looks Markovian on a 30-day time scale for up to 6 months; sovereign debt also looks Markovian (perhaps due to a small sample size); municipals are well-modeled by the Markov specification for up to 5 years, but could probably benefit from frequent updating of the estimated transition matrix or from more sophisticated modeling, and S&P Corporate ratings are approximately Markov over 3 transitions but not 4.

Keywords: Markov, Credit Ratings, Transitions, Simulation Estimator

JEL Classification: C5, C15, C33

Suggested Citation

Larson, C. Erik and Kiefer, Nicholas M., A Simulation Estimator for Testing the Time Homogeneity of Credit Rating Transitions. Journal of Empirical Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=922737

C. Erik Larson (Contact Author)

Promontory Financial Group ( email )

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Suite 617
Washington, DC 20004
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HOME PAGE: http://www.ceriklarson.com

Nicholas M. Kiefer

Cornell University - Department of Economics ( email )

490 Uris Hall
Ithaca, NY 14853-7601
United States

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