Rating Based Modeling of Credit Risk: Theory and Application of Migration Matrices

In the last decade rating-based models have become very popular in credit risk management. These systems use the rating of a company as the decisive variable to evaluate the default risk of a bond or loan. The popularity is due to the straightforwardness of the approach, and to the upcoming new capital accord (Basel II), which allows banks to base their capital requirements on internal as well as external rating systems. Because of this, sophisticated credit risk models are being developed or demanded by banks to assess the risk of their credit portfolio better by recognizing the different underlying sources...
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Rating Based Modeling of Credit Risk: Theory and Application of Migration Matrices Academic Press is an imprint of Elsevier 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA 525 B Street, Suite 1900, San Diego, California 92101-4495, USA 84 Theobald’s Road, London WC1X 8RR, UK Copyright  c 2009 by Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, E-mail: permissions@elsevier.com. You may also complete your request online via the Elsevier homepage (http://www.elsevier.com), by selecting “Support & Contact” then “Copyright and Permission” and then “Obtaining Permissions.” Library of Congress Cataloging-in-Publication Data Application submitted British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: 978-0-12-373683-3 For information on all Academic Press publications visit our Web site at: http://www.elsevierdirect.com Printed in the United States of America 08 09 10 9 8 7 6 5 4 3 2 1 To my parents and Prasheela (S.T.) To Svetlozar Todorov Iotov (S.T.R) Preface Credit risk has become one of the most intensely studied topics in quanti- tative finance in the last decade. A large number of books on the topic have been published in recent years, while on the excellent homepage maintained by Greg Gupton there are more than 1200 downloadable working papers related to credit risk. The increased interest in modeling and management of credit risk in academia seems only to have started in the mid-1990s. However, due to the various issues involved, including the ability to effec- tively apply quantitative modeling tools and techniques and the dramatic rise of credit derivatives, it has become one of the major fields of research in finance literature. As a consequence of an increasingly complex and competitive finan- cial environment, adequate risk management strategies require quantitative modeling know-how and the ability to effectively apply this expertise and its techniques. Also, with the revision of the Basel Capital Accord, various credit risk models have been analyzed with respect to their feasibility, and a significant focus has been put on good risk-management practices with respect to credit risk. Another consequence of Basel II is that most financial institutions will have to develop internal models to adequately determine the risk arising from their credit exposures. It can therefore be expected that in particular the use and application of rating based models for credit risk will be increasing further. On the other hand, it has to be acknowledged that rating agencies are at the center of the subprime mortgage crisis, as they failed to pro- vide adequate ratings for many diverse products in the credit and credit derivative markets like mortgage bonds, asset backed securities, commercial papers, collateralized debt obligations, and derivative products for compa- nies and also for financial institutions. Despite some deficiencies of the current credit rating structure—recommendations for their improvements are thoroughly analyzed in Crouhy et al. (2008) but are beyond the scope of this book—overall, rating based models have evolved as an industry standard. Therefore, credit ratings will remain one of the most important variables when it comes to measurement and management of credit risk. The literature on modeling and managing credit risk and credit deriva- tives has been widely extended in recent years; other books in the area include the excellent treatments by Ammann (2002), Arvanitis and Gre- gory (2001), Bielecki and Rutkowski (2002), Bluhm et al. (2003), Bluhm and Overbeck (2007b), Cossin and Pirotte (2001), Duffie and Singleton (2003), Fabozzi (2006a,b), Lando (2004), Saunders and Allen (2002), and Sch¨onbucher (2003), just to mention a few. However, in our opinion, so far there has been no book on credit risk management mainly focusing xii Preface on the use of transition matrices, which, while popular in academia, is even more widely used in industry. We hope that this book provides a helpful survey on the theory and application of transition matrices for credit risk management, including most of the central issues like estimation techniques, stability and comparison of rating transitions, VaR simula- tion, adjustment and forecasting migration matrices, corporate-yield curve dynamics, dependent migrations, and the modeling and pricing of credit derivatives. While the aim is mainly to provide a review of the existing literature and techniques, a variety of very rece ...