Simulating Dependent Credit Migrations

25 Pages Posted: 17 Feb 2009

See all articles by Stefan Trück

Stefan Trück

Macquarie University Sydney - Department of Applied Finance and Actuarial Studies; Financial Research Network (FIRN); Centre for International Finance and Regulation (CIFR); Macquarie University, Macquarie Business School

Date Written: February 16, 2009

Abstract

We review different methods for simulating credit migrations in a nonparametric and discrete or continuous-time Markov chain framework. We suggest the use of a factor model approach in combination with the use of copulas for the joint dynamics of credit rating changes.While there are several applications of copulas in credit risk for modeling joint defaults, it lacks of the same interest towards modeling dependence in rating migrations. It is well-known, however, that the risk of a credit portfolio is not dependent only on the defaults but also on rating upgrades and downgrades. In a simulation study, we illustrate the effects of considering dependencies in credit migrations for an exemplary loan portfolio. Hereby, we do not only examine default or loss figures for the portfolio, but also the distribution of ratings by the end of the simulated period. Our findings illustrate quite large differences between the different approaches: not only the fact whether dependence is accounted for but also the choice of the copula affects loss figures and the distribution of ratings. Also extreme outcomes for credit migrations like they have been observed during times of a financial crisis can be modeled introducing an adequate level of dependency.

Keywords: Credit Risk, Rating Migrations, Dependence, Markov Chains, Copulas, Simulation

JEL Classification: C10, G21, G33

Suggested Citation

Trueck, Stefan, Simulating Dependent Credit Migrations (February 16, 2009). Available at SSRN: https://ssrn.com/abstract=1344897 or http://dx.doi.org/10.2139/ssrn.1344897

Stefan Trueck (Contact Author)

Macquarie University Sydney - Department of Applied Finance and Actuarial Studies ( email )

North Ryde
Sydney, New South Wales 2109
Australia
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61298508483 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Centre for International Finance and Regulation (CIFR) ( email )

Level 7, UNSW CBD Campus
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Sydney, NSW 2000
Australia

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia