Wozabal, David, Ronald Hochreiter, "A Coupled Markov Chain Approach to Credit Risk Modeling", Journal of Economic Dynamics and Control, Vol. 36, No. 3, (March 2012), pp. 403-415.

Abstract: We propose a Markov chain model for credit rating changes. We do not use any distributional assumptions on the asset values of the rated companies but directly model the rating transitions process. The parameters of the model are estimated by a maximum likelihood approach using historical rating transitions and heuristic global optimization techniques.

We benchmark the model against a GLMM model in the context of bond portfolio risk management. The proposed model yields stronger dependencies and higher risks than the GLMM model. As a result, the risk optimal portfolios are more conservative than the decisions resulting from the benchmark model.

JEL Classification: G11, G01, C44, C14, D81.

Keywords: Credit risk, Markov models, Ratings, Conditional value-at-risk, Bond portfolios.

Previously titled: A Coupled Markov Chain Approach to Risk Analysis of Credit Default Swap Index Products

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