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Analyzing the impact of credit migration in a portfolio setting

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  • Tsaig, Yaakov
  • Levy, Amnon
  • Wang, Yashan

Abstract

Credit migration is an essential component of credit portfolio modeling. In this paper, we outline a framework for gauging the effects of credit migration on portfolio risk measurements. For a typical loan portfolio, we find credit migration can explain as much as 51% of volatility and 35% of economic capital. We compare through-the-cycle migration effects, implied by agency rating transitions, with point-in-time migration, implied by EDF™ (Expected Default Frequency) transitions, and find that migration of point-in-time credit quality accounts for a greater fraction of total portfolio risk when compared with through-the-cycle dynamics. In a stylized analytic setting, we show that, when controlling for PD term structure effects, higher likelihood of moving away from the current credit state does not necessarily imply greater risk. Finally, we review methods for generating high-frequency transition matrices, needed for analyzing instruments with cash flows or contingencies whose frequencies are asynchronous to an available transition matrix. We further demonstrate that the naïve application of such methods can result in material deviations to portfolio analytics.

Suggested Citation

  • Tsaig, Yaakov & Levy, Amnon & Wang, Yashan, 2011. "Analyzing the impact of credit migration in a portfolio setting," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3145-3157.
    • Handle: RePEc:eee:jbfina:v:35:y:2011:i:12:p:3145-3157
    DOI: 10.1016/j.jbankfin.2010.09.027
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    Cited by:

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    2. Dorfleitner, G. & Priberny, C., 2013. "A quantitative model for structured microfinance," The Quarterly Review of Economics and Finance, Elsevier, vol. 53(1), pages 12-22.
    3. Kanno, Masayasu, 2020. "Credit rating migration risk and interconnectedness in a corporate lending network," Research in International Business and Finance, Elsevier, vol. 54(C).
    4. Dimitris Gavalas & Theodore Syriopoulos, 2014. "Bank Credit Risk Management and Migration Analysis; Conditioning Transition Matrices on the Stage of the Business Cycle," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 20(2), pages 151-166, May.
    5. Xing, Haipeng & Sun, Ning & Chen, Ying, 2012. "Credit rating dynamics in the presence of unknown structural breaks," Journal of Banking & Finance, Elsevier, vol. 36(1), pages 78-89.

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    More about this item

    Keywords

    Credit migration; Credit risk; Credit portfolio management; Markov model; Transition matrix;
    All these keywords.

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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