Week 4: Default Probabilities – Part 1
“Introduction … Introduction and Overview … External Credit Ratings … Internal Ratings and Recovery Rates”
- Week 4: Default Probabilities - Part 1 > Lesson 1: Introduction and Overview > Video Lesson
- Week 4: Default Probabilities - Part 1 > Lesson 2: External Credit Ratings > Video Lesson
- Week 4: Default Probabilities - Part 1 > Lesson 3: Internal Ratings and Recovery Rates > Video Lesson
- Week 4: Default Probabilities - Part 1 > Summary > Video
Week 4: Default Probabilities – Part 1 > Lesson 1: Introduction and Overview > Video Lesson
- Simplifying a little bit, we can make use of tools belonging to two important classes: ratings and default models.
- Within the ratings’ class, we can make a distinction between external and internal ratings.
- External ratings are ratings – credit ratings to be more precise – that we obtain from third parties, typically rating agencies, such as Moody’s, Fitch and Standard and Poor’s.
- If we consider the other class, the one of default models, we can make a clear distinction between structural and non-structural models of default.
- A structural model of default is a model in which default happens when the assets of a company reach a sufficiently low level with respect to liabilities.
- This family of models include some of the most important models in credit risk management, such as Merton’s model, and proprietary models like Moody’s KMV and JP Morgan’s CreditMetrics.
- Non-structural models of default include mixture models and other rather sophisticated approaches.
- It is worth noticing that the great majority of methods and models we will consider belong to the internal-rating based approach of Basel II and III.
- Always speaking about PDs, we will also deal with some tools like CDS and credit spreads, and we will see how we can use them to estimate the probability of default of a counterparty.
Week 4: Default Probabilities – Part 1 > Summary > Video
- When you listen to the word “ratings”, most people refer to external ratings, that is those ratings that are given by rating agencies, such as Fitch, for example.
- On the contrary, we always say “internal ratings”, to indicate those ratings that are not acquired from rating agencies.
- For what concerns external ratings, we have said that every rating agency has its own ratings scale, but that the ratings of the top three agencies are considered comparable.
- Ratings fully determine the probability of default of a counterparty.
- We have seen that, even if ratings are always related to a specific bond issue , most of the times all the bonds issued by the same company have the same rating.
- We have also seen that rating agencies provide transition matrices, giving information on the possibility that – say – a AAA bond is downgraded to AA, and tables containing the cumulative probability of default for every rating class.
- Internal ratings are computed by banks and companies themselves.