Transition probability matrix methodology for incremental risk charge

Tzahi Yavin (), Eugene Wang (), Hu Zhang () and Michael A. Clayton ()
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Tzahi Yavin: RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada
Eugene Wang: RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada
Hu Zhang: Morgan Stanley, 150 Seventh Avenue, New York, NY 10019, USA

Journal of Financial Engineering (JFE), 2014, vol. 01, issue 01, 1-47

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; incremental risk charge; transition probability matrix; default probability; default correlation (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1142/S234576861450010X

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