Ratings-based Credit Risk Modelling: An empirical analysis

by Pamela Nickell of Moody's KMV,
William Perraudin of Imperial College, and
Simone Varotto of ISMA Center

May 6, 2005

Abstract: Banks have recently developed new techniques for gauging the credit risk associated with portfolios of illiquid, defaultable instruments. These techniques could revolutionise banks' management of credit risk and could in the longer term serve as a more risk-sensitive basis for calculating regulatory capital on banks' loan books than in Basel 2, the new regulatory capital framework. In this paper we implement a popular credit risk model that exploits the information in credit ratings to determine a portfolio's value-at-risk. Using price data on large Eurobond portfolios, we assess, on an out-of-sample basis, how well the model tracks the risks it is supposed to measure.

JEL Classification: G11, G21, L51.

Keywords: Credit risk models, Value-at-risk.

Published in: International Review of Financial Analysis, Vol. 16, No. 5, (2007), pp. 434-451.

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