Journal of Risk Model Validation
ISSN:
1753-9579 (print)
1753-9587 (online)
Editor-in-chief: Steve Satchell
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Rating philosophy and dynamic properties of internal rating systems: a general framework and an application to backtesting
Marco Morone, Anna Cornaglia
Abstract
ABSTRACT
This paper describes a general framework for asset and default dynamics, separating the influence of the economic cycle into a component that is embedded in the rating system and an unobservable risk factor that determines the movements of defaults around the ex ante estimated probabilities of default. The two components - the sensitivity of ratings to credit cycle and conditional asset correlation - can be quantified through a maximum likelihood approach, giving a measure of the cyclicality of the rating system, and allowing for a number of applications, among them the modified binomial test proposed here.
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