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Implied Migration Rates from Credit Barrier Models

by Claudio Albanese of Imperial College London, and
Oliver X. Chen of the National University of Singapore

March 11, 2005

Abstract: The risk-neutral credit migration process captures quantitative information which is relevant to the pricing theory and risk management of credit derivatives. In this article, we derive implied migration rates by means of a recently introduced credit barrier model which is calibrated on the basis of aggregate information such as credit migration rates and credit spread curves. The model is characterized by an underlying stochastic process that represents credit quality, and default events are associated to barrier crossings. The stochastic process has state dependent volatility and jumps which are estimated by using empirical migration and default rates. A risk-neutralizing drift and forward liquidity spreads are estimated to consistently match the average spread curves corresponding to all the various ratings. The implied migration rates obtained with our credit barrier model are then compared with those obtained via the Jarrow-Lando-Turnbull model and the Kijima-Komoribayashi model in a detailed example.

JEL Classification: G12, G14, G33.

Keywords: Credit risk modelling, Credit ratings, Default probabilities, Credit spreads.

Published in: Journal of Banking & Finance, Vol. 30, No. 2, (February 2006), pp. 607-626.

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