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Ana Maria Fuertes, Cass Business School Print
Thursday, 17 February 2011, 12:15 - 13:15

Credit Ratings Migration and Business Cycles

Ana Maria Fuertes, Cass Business School

ABSTRACT : This paper advocates a mixture of Markov chains (MMC) hazard-rate estimator of credit migration risk that accounts for business-cycle fluctuations. The estimator is contrasted with two classical ones, cohort and hazard-rate, that average through-the-cycle and with a naïve business-cycle estimator that conditions on the economic state. A statistical comparison based on bootstrap simulations shows that the MMC default probabilities are more accurate than the naïve ones during economic downturns. An out-of-sample forecast exercise based on different distance metrics corroborates that the MMC estimator provides improvements in forecast performance relative to the naïve one ranging, for instance for the 1-year horizon, from 13.82% reduction in singular value distance to 3.97% reduction in MAE. An assessment of the economic relevance of this analysis using Value-at-Risk reveals that incorporating business cycles implies substantially more prudent capital buffers during recessions; however, banks opting for the MMC estimator instead of the naïve one can save up to 17% in risk capital holdings.

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