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Effects of downgrade momentum on measuring credit migration risks

Djiambou, Vivien (2009) Effects of downgrade momentum on measuring credit migration risks.

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Abstract:The purpose of this study is to investigate the effects of “downgrade momentum” in credit migration matrices that is observed in rating transition data. The downgrade momentum refers to a non- Markovian effects in which recently downgraded obligors are at increasing risk of experiencing further downgrades. The developed extended transition matrices sensitive to downgrade momentum are used to compute the credit risks for long and short term horizons and later compared to an extended transition matrix insensitive to downgrade momentum. The insensitive extended transition matrix referred as benchmark for comparison has a one-to-one correspondence with the annual S&P’s transition matrix. The first model of the downgrade sensitive extended transition matrix has a one-toone correspondence with the annual transition matrix and recently downgraded probabilities increased by a factor of three for those that will be downgraded in the next period while the second model represents an adjustment of the first model such that it can be aggregated back to the initial annual S&P’s transition matrix. The calibration of the second model is based on the number of obligors within each rating category. In addition, these extended transition matrices are applied in the measurement of short-term credit migration risks referred in Basel II as Incremental Risk Charge. To maintain a constant level of risk, the portfolio is rebalanced each quarter to match with the initial portfolio with the condition that recently downgraded instruments cannot be sold on the market. We illustrate the significance of the downgrade momentum effects on credit migration matrices based on the algorithm developed in MatLab®. The implication of this research affects both short-term and long-term horizons portfolios which are strongly influenced by the dynamics of the rating transitions. The result of this study is relevant for Basel II because banks that neglect the downgrade momentum might underestimate the risk level of their positions.
Item Type:Essay (Master)
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
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