Rating philosophy and dynamic properties of internal rating systems: A general framework and an application to backtesting

Cornaglia, Anna and Morone, Marco (2009): Rating philosophy and dynamic properties of internal rating systems: A general framework and an application to backtesting.

Abstract

The paper draws a general framework for asset and default dynamics, separating the influence of the economic cycle into a component which is embedded in the rating system and an unobservable risk factor that determines the movements of defaults around the ex ante estimated PDs. The two components – the sensitivity of ratings to credit cycle and conditional asset correlation - can be quantified through a Maximum Likelihood approach, giving a measure of the cyclicality of the rating system, and allowing for a number of applications: among those the modified binomial test proposed here.

• Item Type: MPRA Paper
• Language: English
• Keywords: rating philosophy; rating dynamics; cyclicality; asset correlation; migration matrices; ML estimation; backtesting; binomial test
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C13 - Estimation: General; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General

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