Chapter 8. Real-World and Risk-Neutral Transition Matrices

In this chapter we will investigate how real-world or historical transition matrices can be transformed into risk-neutral ones. As we have seen in the previous chapters, the former are rather used to determine Economic Capital or Value-at-Risk for credit portfolios. On the other hand, the use of the latter is rather to construct risk-neutral credit curves for different time horizons and adequately price credit derivatives. Using credit spreads from empirically observed bond prices, in their seminal paper Jarrow et al. (JLT 1997) were the first to suggest methods for transforming real-world transition and default probabilties into risk-neutral ones. Due to some difficulties with the initially ...

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