Calibration of PD term structures: to be Markov or not to be
A common discussion in credit risk modelling is the question of whether term structures of default probabilities can be satisfactorily modelled by Markov chain techniques. Christian Bluhm and Ludger Overbeck show that empirical multi-year default frequencies can be interpolated well by continuous-time Markov chains if the Markov chain is allowed to evolve with non-homogeneous behaviour in time
The probability of default (PD) for a client is a fundamental risk parameter in credit risk management. It is common practice to assign to every rating grade in a bank's master scale a one-year PD in line with regulatory requirements (see Basel Committee on Banking Supervision, 2004). Table A shows an example for default frequencies assigned to rating grades from Standard & Poor's (S&P).
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