On the Risk Neutralization of Transition Matrix

23 Pages Posted: 26 Dec 2011 Last revised: 26 Aug 2013

Date Written: August 2, 2013

Abstract

Risk-neutral transition matrix term structure is an essential component of rating-based credit derivative pricing models. However, generation of suitable risk-neutral transition matrix term structure remains a challenging problem. Many calibration models in the literature either are unstable or result in poor fit to the market implied default probability term structure.

In this paper, we propose a new risk-neutral transition matrix term structure calibration method in which the conditional rating transition matrix is a mixture of Markov chains. Numerical results indicate that the local Markov mixture model is capable of accurately calibrating to a variety of market implied CDS/PD term structure.

Keywords: Transition matrix, risk-neutral transition matrix, Markov mixture model, credit derivative

Suggested Citation

Zhou, Richard, On the Risk Neutralization of Transition Matrix (August 2, 2013). Available at SSRN: https://ssrn.com/abstract=1976977 or http://dx.doi.org/10.2139/ssrn.1976977
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