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Bayesian inference for issuer heterogeneity in credit ratings migration

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  • Kadam, Ashay
  • Lenk, Peter
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    Abstract

    Rating transition matrices for corporate bond issuers are often based on fitting a discrete time Markov chain model to homogeneous cohorts. Literature has documented that rating migration matrices can differ considerably depending on the characteristics of the issuers in the pool used for estimation. However, it is also well known in the literature that a continuous time Markov chain gives statistically superior estimates of the rating migration process. It remains to verify and quantify the issuer heterogeneity in rating migration behavior using a continuous time Markov chain. We fill this gap in the literature. We provide Bayesian estimates to mitigate the problem of data sparsity. Default data, especially when narrowing down to issuers with specific characteristics, can be highly sparse. Using classical estimation tools in such a situation can result in large estimation errors. Hence we adopt Bayesian estimation techniques. We apply them to the Moodys corporate bond default database. Our results indicate strong country and industry effects on the determination of rating migration behavior. Using the CreditRisk+ framework, and a sample credit portfolio, we show that ignoring issuer heterogeneity can give erroneous estimates of Value-at-Risk and a misleading picture of the risk capital. This insight is consistent with some recent findings in the literature. Therefore, given the upcoming Basel II implementation, understanding issuer heterogeneity has important policy implications.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 32 (2008)
    Issue (Month): 10 (October)
    Pages: 2267-2274

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    Handle: RePEc:eee:jbfina:v:32:y:2008:i:10:p:2267-2274

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Credit risk Risk capital Markov chains Bayesian inference Heterogeneity;

    References

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    1. 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.
    2. Asquith, Paul & Mullins, David W, Jr & Wolff, Eric D, 1989. " Original Issue High Yield Bonds: Aging Analyses of Defaults, Exchanges, and Calls," Journal of Finance, American Finance Association, vol. 44(4), pages 923-52, September.
    3. 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.
    4. 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.
    5. Jafry, Yusuf & Schuermann, Til, 2004. "Measurement, estimation and comparison of credit migration matrices," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2603-2639, November.
    6. Christensen, Jens H.E. & Hansen, Ernst & Lando, David, 2004. "Confidence sets for continuous-time rating transition probabilities," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2575-2602, November.
    7. McNeil, Alexander J. & Wendin, Jonathan P., 2007. "Bayesian inference for generalized linear mixed models of portfolio credit risk," Journal of Empirical Finance, Elsevier, vol. 14(2), pages 131-149, March.
    8. Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1996. "Law and Finance," NBER Working Papers 5661, National Bureau of Economic Research, Inc.
    9. Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000. "Stability of rating transitions," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 203-227, January.
    10. Robert B. Israel & Jeffrey S. Rosenthal & Jason Z. Wei, 2001. "Finding Generators for Markov Chains via Empirical Transition Matrices, with Applications to Credit Ratings," Mathematical Finance, Wiley Blackwell, vol. 11(2), pages 245-265.
    11. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
    12. Allenby, Greg M & Lenk, Peter J, 1995. "Reassessing Brand Loyalty, Price Sensitivity, and Merchandising Effects on Consumer Brand Choice," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(3), pages 281-89, July.
    13. Colin Mayer, 1998. "Financial Systems and Corporate Governance: A Review of the International Evidence," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 154(1), pages 144-, March.
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    Citations

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    Cited by:
    1. Tsaig, Yaakov & Levy, Amnon & Wang, Yashan, 2011. "Analyzing the impact of credit migration in a portfolio setting," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3145-3157.
    2. Alsakka, Rasha & ap Gwilym, Owain, 2010. "A random effects ordered probit model for rating migrations," Finance Research Letters, Elsevier, vol. 7(3), pages 140-147, September.
    3. Hill, Paula & Brooks, Robert & Faff, Robert, 2010. "Variations in sovereign credit quality assessments across rating agencies," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1327-1343, June.
    4. Rasha Alsakka & Owain ap Gwilym, 2010. "Sovereign Ratings and Migrations: Emerging Markets," Working Papers 10009, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).
    5. May, Anthony D., 2010. "The impact of bond rating changes on corporate bond prices: New evidence from the over-the-counter market," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2822-2836, November.
    6. Leow, Mindy & Crook, Jonathan, 2014. "Intensity models and transition probabilities for credit card loan delinquencies," European Journal of Operational Research, Elsevier, vol. 236(2), pages 685-694.
    7. Dimitris Gavalas & Theodore Syriopoulos, 2014. "Bank Credit Risk Management and Rating Migration Analysis on the Business Cycle," International Journal of Financial Studies, MDPI, Open Access Journal, vol. 2(1), pages 122-143, March.
    8. Alsakka, Rasha & ap Gwilym, Owain, 2010. "Leads and lags in sovereign credit ratings," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2614-2626, November.
    9. William H. Greene & David A. Hensher, 2008. "Modeling Ordered Choices: A Primer and Recent Developments," Working Papers 08-26, New York University, Leonard N. Stern School of Business, Department of Economics.
    10. Al-Sakka, Rasha & ap Gwilym, Owain, 2009. "Heterogeneity of sovereign rating migrations in emerging countries," Emerging Markets Review, Elsevier, vol. 10(2), pages 151-165, June.

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