As explained in Chapter 15, regulators have for a long time required banks to keep capital for credit risk. Under Basel II banks can, with approval from bank supervisors, use their own estimates of default probabilities to determine the amount of capital they are required to keep. This has led banks to search for better ways of estimating these probabilities.
In this chapter, we discuss a number of different approaches to estimating default probabilities and explain the key difference between risk-neutral and real-world estimates. The material we cover will be used in Chapter 20 when we examine how the price of a derivative in the bilaterally cleared over-the-counter market can be adjusted for counterparty credit risk, and in Chapter 21 when we discuss the calculation of credit value at risk.
19.1 CREDIT RATINGS
As explained in Section 1.7, rating agencies such as Moody’s, S&P, and Fitch provide ratings describing the creditworthiness of corporate bonds.1 Because a credit rating is designed to provide information about credit quality, one might expect frequent changes in credit ratings as positive and negative information reaches the market. In fact, ratings change relatively infrequently. One of the objectives of rating agencies when they assign ratings is ratings stability. For example, they want to avoid ratings reversals, where a company's bonds are downgraded and then upgraded a few weeks later. Ratings therefore change only ...