Analyzing the impact of credit migration in a portfolio setting

Yaakov Tsaig, Amnon Levy and Yashan Wang

Journal of Banking & Finance, 2011, vol. 35, issue 12, 3145-3157

Abstract: Credit migration is an essential component of credit portfolio modeling. In this paper, we outline a framework for gauging the effects of credit migration on portfolio risk measurements. For a typical loan portfolio, we find credit migration can explain as much as 51% of volatility and 35% of economic capital. We compare through-the-cycle migration effects, implied by agency rating transitions, with point-in-time migration, implied by EDF™ (Expected Default Frequency) transitions, and find that migration of point-in-time credit quality accounts for a greater fraction of total portfolio risk when compared with through-the-cycle dynamics. In a stylized analytic setting, we show that, when controlling for PD term structure effects, higher likelihood of moving away from the current credit state does not necessarily imply greater risk. Finally, we review methods for generating high-frequency transition matrices, needed for analyzing instruments with cash flows or contingencies whose frequencies are asynchronous to an available transition matrix. We further demonstrate that the naïve application of such methods can result in material deviations to portfolio analytics.

Keywords: Credit migration; Credit risk; Credit portfolio management; Markov model; Transition matrix (search for similar items in EconPapers)
JEL-codes: C61 G24 G32 (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:35:y:2011:i:12:p:3145-3157

DOI: 10.1016/j.jbankfin.2010.09.027

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