Estimation and prediction of credit risk based on rating transition systems

Abstract: Risk management is an important practice in the banking industry. In this paper we develop a new methodology to estimate and predict the probability of default (PD) based on the rating transition matrices, which relates the rating transition matrices to the macroeconomic variables. Our method can overcome the shortcomings of the framework of Belkin et al. (1998), and is especially useful in predicting the PD and doing stress testing. Simulation is conducted at the end, which shows that our method can provide more accurate estimate than that obtained by the method of Belkin et al. (1998).