An alternative methodology for estimating credit quality transition matrices

Abstract

This study presents an alternative method of estimating credit quality transition matrices using a hazard function model. The model is useful both for testing the validity of the Markovian assumption, frequently made in credit rating applications, and also for estimating transition matrices conditioning on firm-specific and macroeconomic covariates that influence the migration process. The model presented in the paper is likely to be useful in other applications, although extrapolating numerical values of the coefficients outside of the present context is not recommended. Transition matrices estimated this way may be an important tool for a credit risk administration system, in the sense that a practitioner can use them to forecast the future behaviour of clients' ratings, and their possible change of state.