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On Sovereign Credit Migration: A study of alternative estimators and rating dynamics

by Ana-Maria Fuertes of the City University London, and
Elena Kalotychou of the City University London

February 2006

Abstract: This paper investigates the finite-sample behaviour of sovereign credit migration estimators and analyzes the properties of the rating process. Through bootstrap simulations, we compare a discrete multinomial estimator and two continuous hazard rate methods which differ in that one neglects time heterogeneity in the rating process whereas the other accounts for it. The study is based on Moody's ratings 1981-2004 for 72 industrialized and emerging economies. Hazard rate estimators yield more accurate default probabilities. The time homogeneity assumption leads to underestimating the default probability and greater migration risk is inferred upon relaxing it. There is evidence of duration dependence and downgrade momentum effects in the rating process. These findings have important implications for economic and regulatory capital allocation and for the pricing of credit sensitive instruments.

JEL Classification: C13, C41, G21, G28.

Keywords: Sovereign credit risk, Rating transitions, Markov chain, Time heterogeneity, Rating momentum, Duration dependence.

Published in: Computational Statistics & Data Analysis, Vol. 51, No. 7, (April 2007), pp. 3448-3469.

Previously titled: On Sovereign Credit Migration: Small-sample properties and rating evolution

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