A hidden Markov model of credit quality
AbstractThis paper presents a hidden Markov model of credit quality dynamics, and highlights the use of filtering-based estimation methods for models of this kind. We suppose that the Markov chain governing the 'true' credit quality evolution is hidden in 'noisy' or incomplete observations represented by posted credit ratings. Parameters of the model, namely credit transition probabilities, are estimated using the EM algorithm. Filtering methods provide recursive updates of optimal estimates so the model is 'self-calibrating'. The estimation procedure is illustrated with an application to a data set of Standard & Poor's credit ratings.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Economic Dynamics and Control.
Volume (Year): 32 (2008)
Issue (Month): 12 (December)
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Web page: http://www.elsevier.com/locate/jedc
Credit quality Filtering Hidden Markov models EM algorithm;
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- Altman, Edward I., 1998. "The importance and subtlety of credit rating migration," Journal of Banking & Finance, Elsevier, vol. 22(10-11), pages 1231-1247, October.
- Anil Bangia & Francis X. Diebold & Til Schuermann, 2000.
"Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing,"
Center for Financial Institutions Working Papers
00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
- Loffler, Gunter, 2005. "Avoiding the rating bounce: why rating agencies are slow to react to new information," Journal of Economic Behavior & Organization, Elsevier, vol. 56(3), pages 365-381, March.
- Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
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