The structure of credit risk: spread volatility and ratings transitions

ABSTRACT Ratings-based models are widely used by firms making their own capital decisions and by policy-makers designing regulatory capital requirements. By ignoring fluctuations in spreads for given rating categories, the current generation of ratings-based models leaves out a potentially important dimension of risk. This article extends standard ratings-based credit risk models to include spread risk. The main complication in incorporating spread risk is to infer a suitable joint distribution for spread changes over the long horizons that are typically used in portfolio credit risk calculations. Using our generalized credit risk framework, we provide a systematic quantification of different dimensions of credit risk. The key result is that spread fluctuations contribute most of the of risk for higher-rated credits.