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Bayesian Inference for Issuer Heterogeneity in Credit Ratings Migration

by Ashay Kadam of City University, London, and
Peter Lenk of the University of Michigan

September 7, 2007

Abstract: Rating transition matrices for corporate bond issuers are often based on fitting a discrete time Markov chain model to homogeneous cohorts. Literature has documented that rating migration matrices can differ considerably depending on the characteristics of the issuers in the pool used for estimation. However, it is also well known in the literature that a continuous time Markov chain gives statistically superior estimates of the rating migration process. It remains to verify and quantify the issuer heterogeneity in rating migration behavior using a continuous time Markov chain. We fill this gap in the literature. We provide Bayesian estimates to mitigate the problem of data sparsity. Default data, especially when narrowing down to issuers with specific characteristics, can be highly sparse. Using classical estimation tools in such a situation can result in large estimation errors. Hence we adopt Bayesian estimation techniques. We apply them to the Moodys corporate bond default database. Our results indicate strong country and industry effects on the determination of rating migration behavior. Using the CreditRisk+ framework, and a sample credit portfolio, we show that ignoring issuer heterogeneity can give erroneous estimates of Value-at-Risk and a misleading picture of the risk capital. This insight is consistent with some recent findings in the literature. Therefore, given the upcoming Basel II implementation, understanding issuer heterogeneity has important policy implications.

JEL Classification: C11, C13, C41, G12.

Keywords: Credit risk, Risk Capital, Markov Chains, Bayesian Inference, Heterogeneity.

Published in: Journal of Banking & Finance, Vol. 32, No. 10, (October 2008), pp. 2267-2274.

Previously titled: Heterogeneity in Ratings Migration

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