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Transition Probability Matrix Methodology for Incremental Risk Charge

Author

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  • Yavin, Tzahi
  • Zhang, Hu
  • Wang, Eugene
  • Clayton, Michael

Abstract

As part of Basel II's incremental risk charge (IRC) methodology, this paper summarizes our extensive investigations of constructing transition probability matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. We highlight various aspects of three types of uncertainties embedded in different construction methods: 1) the available historical data and the bank's rating philosophy; 2) the merger of one-year Basel PD and the chosen Moody's TPMs; and 3) deriving a monthly or quarterly TPM when the generator matrix does not exist. Given the fact that TPMs and specifically their PDs are the most important parameters in IRC, it is our view that banks may need to make discretionary choices regarding their methodology, with uncertainties well understood and managed.

Suggested Citation

  • Yavin, Tzahi & Zhang, Hu & Wang, Eugene & Clayton, Michael, 2011. "Transition Probability Matrix Methodology for Incremental Risk Charge," MPRA Paper 28740, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:28740
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    File URL: https://mpra.ub.uni-muenchen.de/28740/1/MPRA_paper_28740.pdf
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    References listed on IDEAS

    as
    1. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453 World Scientific Publishing Co. Pte. Ltd..
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    More about this item

    Keywords

    Basel II; trading book; incremental risk charge; default probability; default correlation; transition probability matrix; generator matrix; credit portfolio;

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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