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Credit rating dynamics and Markov mixture models

  • Frydman, Halina
  • Schuermann, Til

Despite mounting evidence to the contrary, credit migration matrices, used in many credit risk and pricing applications, are typically assumed to be generated by a simple Markov process. Based on empirical evidence, we propose a parsimonious model that is a mixture of (two) Markov chains, where the mixing is on the speed of movement among credit ratings. We estimate this model using credit rating histories and show that the mixture model statistically dominates the simple Markov model and that the differences between two models can be economically meaningful. The non-Markov property of our model implies that the future distribution of a firm's ratings depends not only on its current rating but also on its past rating history. Indeed we find that two firms with identical current credit ratings can have substantially different transition probability vectors. We also find that conditioning on the state of the business cycle or industry group does not remove the heterogeneity with respect to the rate of movement. We go on to compare the performance of mixture and Markov chain using out-of-sample predictions.

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

Volume (Year): 32 (2008)
Issue (Month): 6 (June)
Pages: 1062-1075

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Handle: RePEc:eee:jbfina:v:32:y:2008:i:6:p:1062-1075
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. 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.
  2. Frydman, Halina, 2005. "Estimation in the Mixture of Markov Chains Moving With Different Speeds," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 1046-1053, September.
  3. Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000. "Stability of rating transitions," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 203-227, January.
  4. 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.
  5. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
  6. 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.
  7. 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.
  8. 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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