Credit Risk Modeling Using Excel and VBA with DVD

4

Prediction of Default and Transition Rates

Default and transition rates are essential to pricing or risk management. Based on a forecast for next year's default rate, for example, a bank can set appropriate loan rates for short-term loans.

In Chapter 3, we showed how to estimate average transition rates based on data extending over several years. If such rates are used to estimate next year's transition rates, one would implicitly assume the next year to be a typical or average year. Although this may be an appropriate assumption in some situations, in others we may have good reason to believe that the following year should be relatively good or bad for credits. If the economy is just moving into a recession, for example, we should expect default rates to be relatively high.

In this chapter, we show how to use readily available information to predict default and transition rates for corporates rated by a major rating agency. The fact that default and transition rates can indeed be predicted might cast doubt on the efficiency of agency ratings. If there were good reasons to believe, say at the end of 2001, that the default rate of BB-rated issuers was to be relatively high in 2002, why did the agency not downgrade more BB-rated issuers? To understand this, it is crucial to know that agencies do not aim at assigning ratings in such a way that the one-year default probability of a rating category is constant across time. By contrast, ratings are meant to be relative assessments ...