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Structural model of credit migration

Author

Listed:
  • Chan, Ngai Hang
  • Wong, Hoi Ying
  • Zhao, Jing

Abstract

Credit migrations constitute the building blocks of modern risk management. A firm-specific structural model of credit migration that incorporates the firm’s capital structure and the risk perception of rating agencies is proposed. The proposed model employs the notion of distance-to-default, which quantifies default probability. The properties of Brownian excursions play an essential role in the analysis. The proposed model not only allows the derivation of closed-form credit transition probability, but also provides plausible explanations for certain empirical evidence, such as the default probability overlaps in ratings and the slow-to-respond feature of rating agencies. The proposed model is calibrated through simulations and applied to empirical data, which show rating agencies’ risk perceptions to be significant. The calibrated model allows calculation of the firm-specific transition probabilities of rated companies.

Suggested Citation

  • Chan, Ngai Hang & Wong, Hoi Ying & Zhao, Jing, 2012. "Structural model of credit migration," Computational Statistics & Data Analysis, Elsevier, vol. 56(11), pages 3477-3490.
  • Handle: RePEc:eee:csdana:v:56:y:2012:i:11:p:3477-3490
    DOI: 10.1016/j.csda.2010.10.015
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    References listed on IDEAS

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    1. Li, Ka Leung & Wong, Hoi Ying, 2008. "Structural models of corporate bond pricing with maximum likelihood estimation," Journal of Empirical Finance, Elsevier, vol. 15(4), pages 751-777, September.
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    9. 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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    Cited by:

    1. Forster, Jonathan J. & Buzzacchi, Matteo & Sudjianto, Agus & Nagao, Risa, 2016. "Modelling credit grade migration in large portfolios using cumulative t-link transition models," European Journal of Operational Research, Elsevier, vol. 254(3), pages 977-984.
    2. Lin, X. Sheldon & Wu, Panpan & Wang, Xiao, 2016. "Move-based hedging of variable annuities: A semi-analytic approach," Insurance: Mathematics and Economics, Elsevier, vol. 71(C), pages 40-49.

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