Markov regenerative credit rating model

Abstract

Purpose

Credit ratings serve as an important input in several applications in risk management of the financial firms. The level of credit rating changes from time to time because of random credit risk and, thus, can be modeled by an appropriate stochastic process. Markov chain models have been widely used in the literature to generate credit migration matrices; however, emergent empirical evidences suggest that the Markov property is not appropriate for credit rating dynamics. The purpose of this article is to address the non-Markov behavior of the rating dynamics.

Design/methodology/approach

This paper proposes a model based on Markov regenerative process (MRGP) with subordinated semi-Markov process (SMP) to obtain the estimates of rating migration probability matrices and default probabilities. Numerical example is given to illustrate the applicability of the proposed model with the help of historical Standard & Poor’s (S&P) credit rating data.

Findings

The proposed model implies that rating of a firm in the future not only depends on its present rating, but also on its previous ratings. If a firm gets a rating lower than its previous ratings, there are higher chances of further downgrades, and the issue is called the rating momentum. The model also addresses the ageing problem of credit rating evolution.

Originality/value

The contribution of this paper is a more general approach to study the rating dynamics and overcome the issues of inappropriateness of Markov process applied in rating dynamics.

Citation

Pasricha, P., Selvamuthu, D. and Arunachalam, V. (2017), "Markov regenerative credit rating model", Journal of Risk Finance, Vol. 18 No. 3, pp. 311-325. https://doi.org/10.1108/JRF-09-2016-0123