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Transition probability matrix methodology for incremental risk charge

Author

Listed:
  • Tzahi Yavin

    (RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada)

  • Eugene Wang

    (RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada)

  • Hu Zhang

    (Morgan Stanley, 150 Seventh Avenue, New York, NY 10019, USA)

  • Michael A. Clayton

Abstract

As part of Basel II's incremental risk charge (IRC) methodology, this paper summarizes our extensive investigations of constructing transition probability matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. We highlight various aspects of three types of uncertainties embedded in different construction methods: (1) the available historical data and the bank's rating philosophy; (2) the merger of one-year Basel PD and the chosen Moody's TPMs; and (3) deriving a monthly or quarterly TPM when the generator matrix does not exist. Given the fact that TPMs and specifically their PDs are the most important parameters in IRC, it is our view that banks may need to make discretionary choices regarding their methodology, with uncertainties well understood and managed.

Suggested Citation

  • Tzahi Yavin & Eugene Wang & Hu Zhang & Michael A. Clayton, 2014. "Transition probability matrix methodology for incremental risk charge," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 1(01), pages 1-47.
    • Handle: RePEc:wsi:jfexxx:v:01:y:2014:i:01:n:s234576861450010x
    DOI: 10.1142/S234576861450010X
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