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

30 Pages Posted: 12 Jan 2007

See all articles by Nicholas M. Kiefer

Nicholas M. Kiefer

Cornell University - Department of Economics

C. Erik Larson

Promontory Financial Group

Multiple version iconThere are 2 versions of this paper

Date Written: September 2006

Abstract

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 specificatio 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 commerical 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: Ratings transitions, isk measurement, indirect inference, specifictation testing, risk dynamics

JEL Classification: G12, G21, G32, C12, C15, C52

Suggested Citation

Kiefer, Nicholas M. and Larson, C. Erik, A Simulation Estimator for Testing the Time Homogeneity of Credit Rating Transitions (September 2006). Available at SSRN: https://ssrn.com/abstract=956623 or http://dx.doi.org/10.2139/ssrn.956623

Nicholas M. Kiefer (Contact Author)

Cornell University - Department of Economics ( email )

490 Uris Hall
Ithaca, NY 14853-7601
United States

C. Erik Larson

Promontory Financial Group ( email )

1201 Pennsylvania Avenue, NW
Suite 617
Washington, DC 20004
United States
202-384-1200 (Phone)

HOME PAGE: http://www.ceriklarson.com

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