Transition Probability Matrix Methodology for Incremental Risk Charge

Tzahi Yavin, Hu Zhang, Eugene Wang and Michael Clayton

MPRA Paper from University Library of Munich, Germany

Abstract: As part of Basel II's incremental risk charge (IRC) methodology, this paper summarizes our extensive investigations of constructing transition probability matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. We highlight various aspects of three types of uncertainties embedded in different construction methods: 1) the available historical data and the bank's rating philosophy; 2) the merger of one-year Basel PD and the chosen Moody's TPMs; and 3) deriving a monthly or quarterly TPM when the generator matrix does not exist. Given the fact that TPMs and specifically their PDs are the most important parameters in IRC, it is our view that banks may need to make discretionary choices regarding their methodology, with uncertainties well understood and managed.

Keywords: Basel II; trading book; incremental risk charge; default probability; default correlation; transition probability matrix; generator matrix; credit portfolio (search for similar items in EconPapers)
JEL-codes: C02 G21 G28 (search for similar items in EconPapers)
Date: 2011-01-17
New Economics Papers: this item is included in nep-ban, nep-cis and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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