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Modeling rating transitions with instantaneous default

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  • Weißbach, Rafael
  • Strohecker, Fynn

Abstract

The time-continuous discrete-state Markov process is a common model for rating transitions. We present a low-dimensional model that jointly models defaults as a consequence of a cascade of downgrades, as well as an instantaneous default from a good rating grade, and study the resulting maximum-likelihood estimator. By using a martingale limit theorem, we show asymptotic normality. Using a regional cooperative bank portfolio as a sample, reveals that an increase in credit quality is more likely for corporate debtors with poor ratings, while for good ratings, a downgrade is more likely. The effect can be described as a contraction toward medium rating grades.

Suggested Citation

  • Weißbach, Rafael & Strohecker, Fynn, 2016. "Modeling rating transitions with instantaneous default," Economics Letters, Elsevier, vol. 145(C), pages 38-40.
  • Handle: RePEc:eee:ecolet:v:145:y:2016:i:c:p:38-40
    DOI: 10.1016/j.econlet.2016.05.013
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    References listed on IDEAS

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Rafael Weißbach & Patrick Tschiersch & Claudia Lawrenz, 2009. "Testing time-homogeneity of rating transitions after origination of debt," Empirical Economics, Springer, vol. 36(3), pages 575-596, June.
    3. Yongdai Kim & Lancelot James & Rafael Weissbach, 2012. "Bayesian analysis of multistate event history data: beta-Dirichlet process prior," Biometrika, Biometrika Trust, vol. 99(1), pages 127-140.
    4. Kiefer, Nicholas M. & Larson, C. Erik, 2007. "A simulation estimator for testing the time homogeneity of credit rating transitions," Journal of Empirical Finance, Elsevier, vol. 14(5), pages 818-835, December.
    5. Weißbach, Rafael & Walter, Ronja, 2010. "A likelihood ratio test for stationarity of rating transitions," Journal of Econometrics, Elsevier, vol. 155(2), pages 188-194, April.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Rating; Markov process; Maximum-likelihood; Asymptotic normality;
    All these keywords.

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • C34 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Truncated and Censored Models; Switching Regression Models
    • C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies

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