Bayesian Migration in Credit Ratings Based on Probabilities of Default

Posted: 10 Mar 2011 Last revised: 25 Sep 2015

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Rong Fan

Gifford Fong Associates

Gary Geng

Amaranth Advisors llc

Date Written: December 1, 2002

Abstract

The advent of models for computing probabilities of default (PD) has provided a supplementary measure of default likelihood in addition to credit ratings. Credit ratings are a coarser measure of default likelihood, and embed the same information as PDs plus a modicum of human judgment. Rating transitions tend to occur less frequently than PD changes, since the human judgment involved overrides temporary spikes in state variables driving PDs.

We have developed a Bayesian model based on PD changes to mimic rating changes. The free parameters in the model are tuned to historical data to fit the human judgment element in rating transitions.

The model is easy to implement. We generate a simulation-fitted transition matrix that mimics the historical empirical one closely. This lends support to the often-made argument that PDs may be used as sufficient statistics for rating changes. Rating agencies may use this model as a basis for proposing rating changes to credit analysts, and finally, portfolio managers may use the model to obtain forecasts of rating changes, based on the observed historical time series of firm PDs.

Suggested Citation

Das, Sanjiv Ranjan and Fan, Rong and Geng, Gary, Bayesian Migration in Credit Ratings Based on Probabilities of Default (December 1, 2002). Journal of Fixed Income, 2002, Available at SSRN: https://ssrn.com/abstract=1782285

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://srdas.github.io/

Rong Fan

Gifford Fong Associates ( email )

3658 Mt. Diablo Blvd.
Suite 200
Lafayette, CA 94549
United States
925-299-7800 (Phone)

Gary Geng

Amaranth Advisors llc ( email )

Greenwich, CT 06831
United States

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