Confidence Sets for Continuous-time Rating Transition Probabilities

Jens Henrik Eggert Christensen, Ernst Hansen, David Lando

Research output: Working paperResearch

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Abstract

This paper addresses the estimation of default probabilities and associated
confidence sets with special focus on rare events. Research on rating transition data has documented a tendency for recently downgraded issuers to
be at an increased risk of experiencing further downgrades compared to issuers that have held the same rating for a longer period of time. To capture
this non-Markov effect we introduce a continuous-time hidden Markov chain
model in which downgrades firms enter into a hidden, ’excited’ state. Using
data from Moody’s we estimate the parameters of the model, and conclude
that both default probabilities and confidence sets are strongly influenced by
the introduction of hidden excited states.
Original languageEnglish
Number of pages37
Publication statusPublished - 2004

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