Credit rating dynamics in the presence of unknown structural breaks
AbstractIn many credit risk and pricing applications, credit transition matrix is modeled by a constant transition probability or generator matrix for Markov processes. Based on empirical evidence, we model rating transition processes as piecewise homogeneous Markov chains with unobserved structural breaks. The proposed model provides explicit formulas for the posterior distribution of the time-varying rating transition generator matrices, the probability of structural break at each period and prediction of transition matrices in the presence of possible structural breaks. Estimating the model by credit rating history, we show that the structural break in rating transitions can be captured by the proposed model. We also show that structural breaks in rating dynamics are different for different industries. We then compare the prediction performance of the proposed and time-homogeneous Markov chain models.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 36 (2012)
Issue (Month): 1 ()
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Credit risk; Hidden Markov model; Stochastic structural break;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G20 - Financial Economics - - Financial Institutions and Services - - - General
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