IDEAS home Printed from https://ideas.repec.org/p/pra/mprapa/28740.html
   My bibliography  Save this paper

Transition Probability Matrix Methodology for Incremental Risk Charge

Author

Listed:
  • Yavin, Tzahi
  • Zhang, Hu
  • Wang, Eugene
  • Clayton, Michael

Abstract

As part of Basel II's incremental risk charge (IRC) methodology, this paper summarizes our extensive investigations of constructing transition probability matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. We highlight various aspects of three types of uncertainties embedded in different construction methods: 1) the available historical data and the bank's rating philosophy; 2) the merger of one-year Basel PD and the chosen Moody's TPMs; and 3) deriving a monthly or quarterly TPM when the generator matrix does not exist. Given the fact that TPMs and specifically their PDs are the most important parameters in IRC, it is our view that banks may need to make discretionary choices regarding their methodology, with uncertainties well understood and managed.

Suggested Citation

  • Yavin, Tzahi & Zhang, Hu & Wang, Eugene & Clayton, Michael, 2011. "Transition Probability Matrix Methodology for Incremental Risk Charge," MPRA Paper 28740, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:28740
    as

    Download full text from publisher

    File URL: https://mpra.ub.uni-muenchen.de/28740/1/MPRA_paper_28740.pdf
    File Function: original version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Matheus Pimentel Rodrigues & Andre Cury Maialy, 2019. "Measuring Default Risk For A Portfolio Of Equities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(01), pages 1-21, February.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Ammann, Manuel & Kind, Axel & Wilde, Christian, 2003. "Are convertible bonds underpriced? An analysis of the French market," Journal of Banking & Finance, Elsevier, vol. 27(4), pages 635-653, April.
    2. Bjork, Tomas, 2009. "Arbitrage Theory in Continuous Time," OUP Catalogue, Oxford University Press, edition 3, number 9780199574742.
    3. Hong-Ming Yin & Jin Liang & Yuan Wu, 2018. "On a New Corporate Bond Pricing Model with Potential Credit Rating Change and Stochastic Interest Rate," JRFM, MDPI, vol. 11(4), pages 1-12, December.
    4. Augusto Castillo, 2004. "Firm and Corporate Bond Valuation: A Simulation Dynamic Programming Approach," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 41(124), pages 345-360.
    5. Nusrat Jahan, 2022. "Macroeconomic Determinants of Corporate Credit Spreads: Evidence from Canada," Carleton Economic Papers 22-07, Carleton University, Department of Economics.
    6. SOLNIK, Bruno & COLLIN-DUFRESNE, Pierre, 2000. "On the term structure of default premia in the Swap and Libor markets," HEC Research Papers Series 704, HEC Paris.
    7. Regis Houssou & Olivier Besson, 2010. "Indifference of Defaultable Bonds with Stochastic Intensity models," Papers 1003.4118, arXiv.org.
    8. Michael C. Munnix & Rudi Schafer & Thomas Guhr, 2011. "A Random Matrix Approach to Credit Risk," Papers 1102.3900, arXiv.org, revised Jun 2011.
    9. Meng-Jou Lu & Cathy Yi-Hsuan Chen & Wolfgang Karl Härdle, 2017. "Copula-based factor model for credit risk analysis," Review of Quantitative Finance and Accounting, Springer, vol. 49(4), pages 949-971, November.
    10. Vink, Dennis, 2007. "An Empirical Analysis of Asset-Backed Securitization," MPRA Paper 10382, University Library of Munich, Germany, revised 25 Aug 2008.
    11. Hugo Storm & Thomas Heckelei & Ron C. Mittelhammer, 2016. "Bayesian estimation of non-stationary Markov models combining micro and macro data," European Review of Agricultural Economics, Oxford University Press and the European Agricultural and Applied Economics Publications Foundation, vol. 43(2), pages 303-329.
    12. Edward J. Elton & Martin J. Gruber & Deepak Agrawal & Christopher Mann, 1999. "Explaining the Rate Spread on Corporate Bonds," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-082, New York University, Leonard N. Stern School of Business-.
    13. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
    14. Saar, Dan & Yagil, Yossi, 2015. "Forecasting growth and stock performance using government and corporate yield curves: Evidence from the European and Asian markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 37(C), pages 27-41.
    15. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    16. Batten, Jonathan & Hogan, Warren, 2002. "A perspective on credit derivatives," International Review of Financial Analysis, Elsevier, vol. 11(3), pages 251-278.
    17. Valerio Vacca, 2011. "An unexpected crisis? Looking at pricing effectiveness of different banks," Temi di discussione (Economic working papers) 814, Bank of Italy, Economic Research and International Relations Area.
    18. Lara Cathcart & Lina El-Jahel, 2006. "Pricing defaultable bonds: a middle-way approach between structural and reduced-form models," Quantitative Finance, Taylor & Francis Journals, vol. 6(3), pages 243-253.
    19. Simonne Varotto, 2001. "Credit Risk Diversification," ICMA Centre Discussion Papers in Finance icma-dp2001-07, Henley Business School, University of Reading.
    20. Jobst, Norbert J. & Zenios, Stavros A., 2005. "On the simulation of portfolios of interest rate and credit risk sensitive securities," European Journal of Operational Research, Elsevier, vol. 161(2), pages 298-324, March.

    More about this item

    Keywords

    Basel II; trading book; incremental risk charge; default probability; default correlation; transition probability matrix; generator matrix; credit portfolio;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pra:mprapa:28740. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Joachim Winter (email available below). General contact details of provider: https://edirc.repec.org/data/vfmunde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.