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Rating philosophy and dynamic properties of internal rating systems: A general framework and an application to backtesting

Author

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  • Cornaglia, Anna
  • Morone, Marco

Abstract

The paper draws a general framework for asset and default dynamics, separating the influence of the economic cycle into a component which is embedded in the rating system and an unobservable risk factor that determines the movements of defaults around the ex ante estimated PDs. The two components – the sensitivity of ratings to credit cycle and conditional asset correlation - can be quantified through a Maximum Likelihood approach, giving a measure of the cyclicality of the rating system, and allowing for a number of applications: among those the modified binomial test proposed here.

Suggested Citation

  • Cornaglia, Anna & Morone, Marco, 2009. "Rating philosophy and dynamic properties of internal rating systems: A general framework and an application to backtesting," MPRA Paper 14711, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:14711
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    File URL: https://mpra.ub.uni-muenchen.de/14711/1/MPRA_paper_14711.pdf
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    References listed on IDEAS

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    1. Dirk Tasche, 2006. "Validation of internal rating systems and PD estimates," Papers physics/0606071, arXiv.org.
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    Cited by:

    1. Sokolov, Yuri, 2010. "Business cycle effects on portfolio credit risk: A simple FX Adjustment for a factor model," MPRA Paper 27222, University Library of Munich, Germany.
    2. Michael Kalkbrener & Akwum Onwunta, 2009. "Validating Structural Credit Portfolio Models," Working Papers 014, COMISEF.

    More about this item

    Keywords

    rating philosophy; rating dynamics; cyclicality; asset correlation; migration matrices; ML estimation; backtesting; binomial test;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General

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