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Practice paper

Smoothing transition probability matrices under a risk sensitive approach

Ahmet Perilioglu and Karina Perilioglu
Journal of Risk Management in Financial Institutions, 10 (4), 395-411 (2017)
https://doi.org/10.69554/BXRL6284

Abstract

Rating transition probability matrices are a crucial parameter not only for the credit risk models but also for pricing and investment decisions. Owing to scarce data and temporal observations, however, empirical transition probability matrices do not show intuitive behaviours and a smoothing methodology, which considers the term structure of transition probabilities, is required. This paper investigates and addresses various issues related to rating migration and default probabilities. The study introduces a smoothing methodology on the transition probability matrices using an optimisation algorithm that leads to consistency with empirical observations and desired theoretical properties. The model completes the previous studies in this area and has a flexible target set-up. It is sensitive to the risk measurements and it serves for a reliable and consistent capital management. A loss function which considers the rating migrations costs in reference portfolio is applied and further portfolio credit risk simulations are performed to estimate the impact of the smoothing.

Keywords: transition probability; credit risk; credit rating; smoothing; term structure of default probabilities; optimisation

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Author's Biography

Ahmet Perilioglu is a senior financial engineer for IBM Risk Analytics, London. He holds an MSc in financial engineering from Bosphorus University, a BA in economics from Istanbul University and is a certified financial risk manager from GARP.

Karina Perilioglu is a manager of required capital assumptions and methodology team for Aviva PLC, London. She holds a PhD in mathematics from Yeditepe University, and an MSc and BSc in financial and actuarial mathematics, both from Vilnius University.

Citation

Perilioglu, Ahmet and Perilioglu, Karina (2017, October 1). Smoothing transition probability matrices under a risk sensitive approach. In the Journal of Risk Management in Financial Institutions, Volume 10, Issue 4. https://doi.org/10.69554/BXRL6284.

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cover image, Journal of Risk Management in Financial Institutions
Journal of Risk Management in Financial Institutions
Volume 10 / Issue 4
© Henry Stewart
Publications LLP

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