Transition Probability Matrix Methodology for Incremental Risk Charge
AbstractAs 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.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 28740.
Date of creation: 17 Jan 2011
Date of revision:
Basel II; trading book; incremental risk charge; default probability; default correlation; transition probability matrix; generator matrix; credit portfolio;
Find related papers by JEL classification:
- C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-19 (All new papers)
- NEP-BAN-2011-02-19 (Banking)
- NEP-CIS-2011-02-19 (Confederation of Independent States)
- NEP-RMG-2011-02-19 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
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