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Parameterizing credit risk models with rating data

  • Mark Carey
  • Mark Hrycay
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    Estimates of average default probabilities for borrowers assigned to each of a financial institution's internal credit risk rating grades are crucial inputs to portfolio credit risk models. Such models are increasingly used in setting financial institution capital structure, in internal control and compensation systems, in asset-backed security design, and are being considered for use in setting regulatory capital requirements for banks. This paper empirically examines properties of the major methods currently used to estimate average default probabilities by grade. Evidence of potential problems of bias, instability, and gaming is presented. With care, and perhaps judicious application of multiple methods, satisfactory estimates may be possible. In passing, evidence is presented about other properties of internal and rating-agency ratings.

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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2000-47.

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    Date of creation: 2000
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    Handle: RePEc:fip:fedgfe:2000-47
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    1. Altman, Edward I. & Suggitt, Heather J., 2000. "Default rates in the syndicated bank loan market: A mortality analysis," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 229-253, January.
    2. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Ratings versus equity-based credit risk modelling: an empirical analysis," Bank of England working papers 132, Bank of England.
    3. William B. English & William R. Nelson, 1999. "Bank risk rating of business loans," Proceedings 619, Federal Reserve Bank of Chicago.
    4. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Stability of ratings transitions," Bank of England working papers 133, Bank of England.
    5. Delianedis, Gordon & Geske, Robert, 1998. "Credit Risk and Risk Neutral Default Probabilities: Information About Migrations and Defaults," University of California at Los Angeles, Anderson Graduate School of Management qt7dm2d31p, Anderson Graduate School of Management, UCLA.
    6. Mark Carey, 1998. "Credit Risk in Private Debt Portfolios," Journal of Finance, American Finance Association, vol. 53(4), pages 1363-1387, 08.
    7. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
    8. Michael B. Gordy, 2000. "Credit VAR and risk-bucket capital rules: a reconciliation," Proceedings 685, Federal Reserve Bank of Chicago.
    9. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-64, May.
    10. Chunsheng Zhou, 1997. "Default correlation: an analytical result," Finance and Economics Discussion Series 1997-27, Board of Governors of the Federal Reserve System (U.S.).
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