Stress Testing and Modeling of Rating Migration under the Vasicek Model Framework - Empirical approaches and technical implementation

Bill Huajian Yang and Zunwei Du

MPRA Paper from University Library of Munich, Germany

Abstract: Under the Vasicek asymptotic single risk factor model, stress testing based on rating transition probability involves three components: the unconditional rating transition matrix, asset correlations, and stress testing factor models for systematic downgrade (including default) risk. Conditional transition probability for stress testing given systematic risk factors can be derived accordingly. In this paper, we extend Miu and Ozdemir’s work ([14]) on stress testing under this transition probability framework by assuming different asset correlation and different stress testing factor model for each non-default rating. We propose two Vasicek models for each non-default rating, one with a single latent factor for rating level asset correlation, and another multifactor Vasicek model with a latent effect for systematic downgrade risk. Both models can be fitted effectively by using, for example, the SAS non-linear mixed procedure. Analytical formulas for conditional transition probabilities are derived. Modeling downgrade risk rather than default risk addresses the issue of low default counts for high quality ratings. As an illustration, we model the transition probabilities for a corporate portfolio. Portfolio default risk and credit loss under stress scenarios are derived accordingly. Results show, stress-testing models developed in this way demonstrate desired sensitivity to risk factors, which is generally expected.

Keywords: Stress testing; systematic risk; asset correlation; rating migration; Vasicek model; bootstrap aggregation (search for similar items in EconPapers)
JEL-codes: C1 C10 C13 C5 G3 G30 G32 G38 (search for similar items in EconPapers)
Date: 2015-06-18
New Economics Papers: this item is included in nep-ecm, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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