page 1
$:D\WR&RQGLWLRQWKH7UDQVLWLRQ0DWUL[RQ:LQG
Jongwoo Kim
RiskMetrics Group
+1-212- 981-7451
jongwoo.kim@riskmetrics.com
Author wishes to thank Lea
V. Carty and David Hamilton
of Moody’s Investors Service
for precious data, Chris Beels
of RiskMetrics Group for fan-
tastic CTM Builder web
page, and Christopher C.
Finger and David Li of Risk-
Metrics Group and Hamilton
Hinds of the Royal Bank of
Scotland for helpful com-
ments.
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Over the last several years a number of credit risk models have been developed to measure
future credit loss based on transitions in credit ratings, including default. In such models, the
matrix of ratings transition probabilities, the so-called transition matrix, plays a crucial role in
the calculation of the joint distribution of ratings for bonds that compose a portfolio. Wilson
(1997) suggests a basic concept for constructing the transition matrix by postulating that the
matrix is conditional on macroeconomic states, Belkin, Forest, and Suchower (1998) present a
one-parameter representation of credit risk and transition matrices, and Nickell, Perraudin, and
Varotto (1998) show that different transition matrices are identified across various factors, such
as the obligor’s domicile and industry and the stage of business cycle. The Basle Committee on
Banking Supervision (1999) also emphasizes the importance of the conditional transition matrix
vis-à-vis its ability to improve the accuracy of the credit risk models.
Previous studies, however, are difficult to apply to current credit risk models, since they use a
large amount of panel data and/or focus on fitting retrospectively, rather than forecasting or
stress testing the future transition matrix. In this paper, we describe a proposed model for esti-
mating the conditional transition matrix. The idea is to adopt an established framework with a
minimal number of parameters and a minimal amount of required data, within which we could
incorporate credit cycle dynamics into the transition matrix. The technique of conditional tran-
sition matrix improves the accuracy of credit loss simulation provided by the credit risk models
and yields an efficient method for stress testing according to the analyst’s view of the future
economic state.
To implement the technique, we first build a credit cycle index, which indicates the credit state
of the financial market as a whole. The model of building the credit cycle index needs to include
the most relevant macroeconomic and financial series, such that the forecasted credit cycle
index represents the credit state well, even with only a small number of series. The next step is
conditioning the transition matrix on the forecasted credit cycle index. The model of condi-
tioning the transition matrix should cover events that lead to upgrading and downgrading, as
well as default. Furthermore, the estimated results should be stable enough to apply to fore-
casting or stress testing of the transition matrix. To show how the technique of conditional tran-
sition matrix improves the accuracy of credit loss simulation, we present an example from
CreditMetrics.
%XLOGLQJDFUHGLWF\FOHLQGH[
The credit cycle index Z t defines the credit state shared by all obligors during period t. We
design the index to be positive in good days, implying a lower downgrading and default proba-
bility and a higher upgrading probability and the index to be negative in bad days, implying a
higher downgrading and default probability and a lower upgrading probability.
A simple way to construct Z t is to calculate the default probabilities of all the credit rated bonds.
Given that highly rated bonds have very low default probabilities that are also insensitive to
economic state, we calculate the default probabilities by using speculative grade bonds (rated
equal to and lower than Moody’s Ba rating) following Wilson (1997). To make Z t follow a stan-
dard normal distribution, we apply the standard normal distribution transformation:1
–1
Φ ( SDP t ) – µ –1
Φ ( SDP )
[1] Z t = – ---------------------------------------------------------t- ,
σ –1
Φ ( SDP t )
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where SDP t is a speculative grade default probability of period t, Φ is a normal cumulative

–1
density function (CDF). Thus, Φ ( SDP t ) means the inverse normal CDF of a speculative grade
default probability. µ and σ denote the historical average and the standard deviation, respec-
tively.

At this point, the question is how to forecast future SDP (more exactly, the inverse normal CDF
of a speculative grade default probability). First we introduce a probit model and estimate the
relationship between macroeconomic series and SDP. We then backtest the forecasted credit
cycle index to show how robust our probit model is for building the credit cycle index.

$SURELWPRGHO
Many macroeconomic institutes build the dynamics of a business cycle by using macroeconomic
and financial series. We can apply the same method to build a credit cycle. Since the SDP is
restricted to lie between 0 and 1, we would be better off using the probit or logit model rather
than the simple regression model. We will use the probit model because we assume that defaults
reflect an underlying, continuous credit-change indicator and the indicator has a standard
normal distribution following CreditMetrics.

[2] SDP t = Φ ( X t – 1 β + ε t ) ,

where X t – 1 is a set of macroeconomic and financial series at period (t-1), β is an unknown coef-
ficient which we need to estimate, and ε t is a random error term such that E t – 1 ( ε t ) = 0 . E t – 1
is the expectation operator with the information of period (t-1).

The inverse normal CDF transformation converts Eq. [2] to a linear regression

–1
[3] Φ ( SDP t ) = X t – 1 β + εt ,

and we estimate β using the ordinary least square (OLS) estimation. Then, the forecasted
inverse normal CDF of SDP is

–1
[4] E t – 1 ( Φ ( SDP t ) ) = X t – 1 β̂ ,

where β̂ is an estimated coefficient.

The probit model allows an analyst to create an unbiased forecast of the inverse normal CDF of
SDP, given recent information about the economic state and the estimated coefficient.

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We estimated the probit model by using a quarterly SDP, which we calculated from Moody’s data
covering the period 1984:4Q to 1998:3Q.2 To estimate the probit model, we investigated various
macroeconomic and financial series that were spread between Aaa and Baa of Moody’s ratings,

1 It is worth noting that in the case of many SDPs bounded by zero, the distribution of Z t is still skewed to
the left even after the standard normal distribution transformation is applied. However, in this paper we
used Moody’s aggregated quarterly SDP and observed only one case of the SDP bounded by zero after
the fourth quarter of 1984.
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spread between the 10-year treasury bond and 3-month treasury bill, the yield of the 10-year
treasury bond, the yield of the 3-month treasury bill, growth of DJIA, growth of S&P 500, trade
balance, CPI inflation, growth of GDP, growth of money supply (M2), and trade-weighted
foreign exchange rate. Finally, for X t – 1 , we chose the spread between Aaa and Baa, the yield
of 10-year treasury bond, the quarterly CPI inflation, and the quarterly growth of GDP based on
2
estimated R .

Chart 1 plots the four macroeconomic and financial series and their relationship to SDP.

2 To calculate SDP, we take a simple average of the default probability of Ba, B and Caa.
 page 4

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Chart 1
Speculative grade default probability and four macroeconomic series

0.15 200

Spread (basis point)

150
0.10
SDP

100
0.05
50
0.00 0
Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98

T-Bond Rate (percent)

0.15 15.0

0.10 10.0
SDP

0.05 5.0

0.00 0.0
Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98

CPI Inflation (percent)

0.15 2.5
2.0
0.10 1.5
SDP

1.0
0.05 0.5
0.0
0.00 -0.5
Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98
GDP Growth (percent)

0.15 3.0
2.0
0.10
1.0
SDP

0.0
0.05
-1.0
0.00 -2.0
Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98

We may expect a positive relationship between SDP and the credit spread and yield of the 10-
year treasury bond. Credit spread is the compensation for holding a lower-grade bond. So,
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higher credit spread means that people expect higher default probability. A higher interest rate
results from a shortage of lending funds in the economy and leads to larger financial costs for
the firm. Both cases induce a larger default probability. Also, we may expect a negative relation-
ship between SDP and the growth of GDP. In a high (low) growth period, a firm’s profit and cash
flow increase (decrease) and thereby reduce (increase) default probability. However, the rela-
tionship between SDP and the CPI inflation is ambiguous. A mild inflation helps firms to
increase their sales margin (negative relationship), but a rapid inflation makes it difficult for
firms to renew their debt (positive relationship).

Here we provide the result of estimation: we are now at the end of the second quarter of 1998
and try to construct the credit cycle index of the third quarter. (The realized credit cycle index
of the third quarter was 1.0214).

The unconditional approach uses a simple average of historical data. Thus, the third-quarter
inverse normal CDF of SDP is simply the average inverse normal CDF of SDP of the past 56 quar-
ters (counting back from the third quarter of 1998) and the credit cycle index is equal to zero by
definition.

We estimate the probit model of Eq. [3] by using SDP and four sets of macroeconomic and finan-
cial data from the past 56 quarters, as shown in Table 1, row 1. The sample size of 56 quarters is
approximately three average business cycle spans of post-World War II.

Table 1
Estimation of the credit cycle index
Credit T-Bond CPI GDP Inverse Credit
Constant Spread 10-year Inflation Growth Normal Cycle
(bp) (%) (%) (%) of SDP Index
β̂ (A) −2.0899 0.0004 0.0025 0.2308 −0.1306
Average (B) 1 94 7.71 0.81 0.74
C = B × A’ −2.0899 00413 0.0196 0.1864 −0.0963 −1.9389 0.0000
1998:2Q (D) 1 60 5.50 0.55 1.14
E = D × A’ −2.0899 0.0265 0.0140 0.1278 −0.1484 −2.0701 0.2626

The signs of the estimated coefficient (row A) match what we expected. Row B shows the
average value of the macroeconomic series during the sample period. If the value of the macro-
economic series in one quarter is exactly the same as the average of the macroeconomic series
in the past 56 quarters, then we can forecast the inverse normal CDF of SDP for next quarter to
be −1.9389 (= B × A’ ). The mean and standard deviation of the inverse normal CDF of SDP
during the sample period are −1.9389 and 0.4995, respectively. Then, the credit cycle index for
next quarter is zero by the standard normal distribution transformation of Eq. [1].

If the macroeconomic series of the second quarter of 1998 D equals the average of the past 56
quarters C, we forecast the third-quarter credit cycle index to equal the average credit cycle
index (zero) of the past 56 quarters. However, the current series differs from the average, and
the forecasted credit cycle index is 0.2626. Hence, we may expect the third quarter of 1999 to be
a better credit situation than the average quarter.

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To show how robust our probit model is for building the credit cycle index, we need to imple-
ment backtesting to large size of out-of-sample. The backtesting period starts from the first
quarter of 1991 and ends with the third quarter of 1998.
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Chart 2 plots the realized SDP and the forecasted credit cycle index. The forecasted credit cycle
index clearly shows an inverse relationship with the realized SDP through both the notorious
credit crunch (1991–1993) and the current bull market (1994–1998).

Chart 2
Realized SDP and forecasted credit cycle index

Forecasted Credit Cycle Index

0.20

0.5
Realized SDP

0.15

0
0.10

0.05 -0.5

0.00 -1
Mar-91 Mar-93 Mar-95 Mar-97

We use the mean absolute error (MAE) as an accuracy measure and the simple average (uncon-
ditional approach) of the past 56 quarters as a benchmark. Table 2 shows the ratio of our probit
model’s MAE to the benchmark MAE. Our probit model reduces forecasting errors by more than
30% compared to the benchmark. Specifically, our probit model provides better forecasts in the
recent bull market than in the credit-crunch period.

Table 2
Backtesting forecasts of the credit cycle index
Sample Period MAE(Conditioanl/Unconditional)
Credit Crunch (1991–93) 0.8138
Bull Market (1994–97) 0.5566
Total Mean (1990–97) 0.6561

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Following CreditMetrics and Belkin, Forest, and Suchower (1998), we assume that ratings tran-
sitions reflect an underlying, continuous credit-change indicator Y.3 We further assume that Y
has a standard normal distribution. Then, conditional on an initial credit rating G at the begin-
G G
ning of a period, we partition the Y values into a set of disjoint bins ( y g , y g + 1 ].

3 Under Merton model, the interpretation of the credit-change indicator is underlying value of firm.
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We write the conditions defining the bins as follows:

G G
[5] P ( G, g ) = Φ ( y g + 1 ) – Φ ( y g ) ,

where P(G, g) denotes G-to-g transition probability.

Our next task is to adjust the next-period transition matrix based on the forecasted credit cycle
index in the previous section. First we introduce an ordered probit model, then show the estima-
tion procedure and backtesting result.

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We assume that Y t has a linear relationship to the credit cycle index Z t , which is defined in
Eq. [1], as Belkin, Forest, and Suchower (1998) did.

2
[6] Y t = γZ t + 1 – γ ε t

where γ is an unknown coefficient that we need to estimate, Z t is the credit cycle index, and ε t
is the error term, which represents the idiosyncratic component. Both Z t and ε t are scaled to the
standard normal distribution such that Y t follows a normal distribution, and its variance always
equals one.4 Then, the coefficient γ represents the correlation between the credit change indi-
cator Y t and the credit cycle index Z t .

Chart 3 shows how Eq. [6] conditions the credit-change indicator on the credit cycle index. Let’s

assume the default event threshold is −2 and the unknown parameter γ is 0.5. On average days,

the credit cycle index Z t equals 0 and the credit-change indicator Y t follows a normal distribu-

tion (middle curve). Its default probability is 0.0104 (= prob( Y t < – 2 Z t = 0 ) =

–2
prob( ε t < ---------------------- )). If we assume that current times are good (e.g., Z t = 2 ), the distribution of
2
(1 – γ )
the credit-change indicator moves to the right-hand side by 1 (= γZ t = 0.5 × 2 ). Its default prob-
–3
ability shrinks to 0.0003 (= prob( Y t < – 2 Z t = 2 ) = prob( ε t < ---------------------- )). On the contrary, on bad
2
(1 – γ )
days (e.g., Z t = – 2 ), the distribution moves to the left-hand side by −1 and its default probability
–1
increases to 0.1240 (= prob( Y t < – 2 Z t = – 2 ) = prob( ε t < ---------------------- )).
2
(1 – γ )

4 It is not necessary for Z t to follow a normal distribution in order to apply the ordered probit model.
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Chart 3
Conditioning credit-change indicator on credit cycle index

0.45
0.40 Bad Days Good Days
0.35 (Z = -2) (Z = 2)
0.30
probability

0.25
0.20
0.15 Default Area
0.10
0.05
0.00
-5 -4 -3 -2 -1 0 1 2 3 4 5
credit-change indicator

Let’s apply the above scheme to a multi-rating system. The conditional G-to-g transition proba-
bility on the credit cycle index Z t which is defined by bins, has the ordered probit model.

G G
 y g + 1 – γ̂Z t  y g – γ̂Z t
[7] P t ( G, g Z t ) = Φ  ------------------------
- – Φ  ------------------
-
 1 – γ̂  2  1 – γ̂ 2 

G G
where y g + 1 and y g are bins calculated from the average transition matrix and γ̂ is the estimated
coefficient. For the procedure of estimating the ordered probit model, refer to Maddala (1983).

(VWLPDWLRQ
We estimated the ordered probit model by using Moody’s quarterly transition matrix for eight
grades, including default, from 1984:4Q to 1998:3Q. The credit cycle index is constructed by
using Eq. [1] with the forecasted inverse normal CDF of SDP.

Here we provide the result of the estimation: we are now at the end of the second quarter of 1998
and forecast the transition matrix for the third quarter. The realized third-quarter transition
matrix is shown in Table 3 and the realized credit cycle index is 1.0214.
 page 9

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Table 3
Realized transition matrix for 1998:3Q
From\To Aaa Aa A Baa Ba B Caa Default
Aaa 97.87 2.13 0.00 0.00 0.00 0.00 0.00 0.00
Aa 0.00 100.00 0.00 0.00 0.00 0.00 0.00 0.00
A 0.00 1.14 97.24 1.62 0.00 0.00 0.00 0.00
Baa 0.00 0.00 0.69 97.74 1.56 0.00 0.00 0.00
Ba 0.00 0.00 0.59 1.37 96.67 0.98 0.39 0.00
B 0.00 0.00 0.00 0.15 1.68 96.17 1.38 0.61
Caa 0.00 0.00 0.00 0.00 0.00 0.00 98.47 1.53

The unconditional approach uses a simple average of historical data. The average transition
matrix for the past 56 quarters is shown in Table 4. Whenever an analyst uses the unconditional
transition matrix, she unconsciously confirms a hidden assumption: the credit cycle index of
current period is zero since the average credit cycle index is zero by definition.

Table 4
Unconditional transition matrix for 1998:3Q
From\To Aaa Aa A Baa Ba B Caa Default
Aaa 98.44 1.50 0.04 0.00 0.02 0.00 0.00 0.00
Aa 0.20 97.01 2.68 0.05 0.04 0.02 0.00 0.00
A 0.01 0.49 97.85 1.48 0.14 0.03 0.00 0.00
Baa 0.01 0.06 1.62 96.61 1.48 0.20 0.01 0.02
Ba 0.01 0.01 0.12 1.41 95.95 2.23 0.02 0.26
B 0.00 0.01 0.05 0.14 1.67 95.28 0.91 1.93
Caa 0.00 0.00 0.00 0.54 0.41 1.46 88.02 9.56

We estimate Eq. [6] by using the transition matrix and the credit cycle index of the past 56 quar-
ters. The method for estimating the ordered (multi-categorical) probit model is the same as for
estimating the previous (bi-categorical) probit model, except that the ordered probit model uses
the bin of credit rating thresholds as intercepts of the equation.5 The estimated parameter, γ̂ , is
ˆ ˆ
0.0537 (= γ I ) for the investment grade and 0.3384 (= γ S ) for the speculative grade.

Let’s build a conditional transition matrix based on the macroeconomic series of the third quarter
of 1998. The forecasted credit cycle index for the third quarter ( Z t ) is 0.2626. We then shift the
ˆ
credit-change indicator by 0.0141 (= γ I Z t = 0.0537 × 0.2626 ) for the investment grade and by
ˆ
0.0889 (= γ S Z t = 0.3384 × 0.2626 ) for the speculative grade. After we apply 0.0141 and 0.0889 to
the normal CDF (Eq. [7] of the ordered probit model), we adjust the average transition matrix

5 We considered two methods to estimate parameter, γ . One method is to estimate γ for each credit rat-
ing. It can incorporate different sensitivity of each credit rating to the credit cycle index but the esti-
mated parameters, γ̂ s, are unstable because of small sample size. The other method is to estimate γ for
two pools of credit rating - the investment grade and speculative grade. It provides only two representa-
tive γ̂ s but the γ̂ s are stable because of large sample size. The estimated results of each credit rating
method showed the overfitting or data-snooping problem. It provides an excellent in-sample fit but poor
out-of-sample performance. Hence, we continuously use two pools of credit rating method here.
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(Table 4) by increasing the probability of up-grades and reducing the probabilities of default and
down-grades

Table 5
Conditional transition matrix for 1998:3Q
From\To Aaa Aa A Baa Ba B Caa Default
Aaa 98.51 1.43 0.03 0.00 0.02 0.00 0.00 0.00
Aa 0.21 97.11 2.57 0.05 0.04 0.02 0.00 0.00
A 0.01 0.50 97.91 1.41 0.13 0.03 0.00 0.00
Baa 0.01 0.06 1.67 96.63 1.42 0.19 0.01 0.02
Ba 0.01 0.01 0.09 1.33 97.13 1.33 0.01 0.10
B 0.00 0.01 0.04 0.11 1.59 96.58 0.60 1.07
Caa 0.00 0.00 0.00 0.46 0.39 1.46 90.91 6.78

%DFNWHVWLQJ
In the above estimation, our conditional approach improves better forecast of the transition
matrix than unconditional approach, but for the general conclusion we need to implement back-
testing. Our backtesting period starts from the first quarter of 1991 and ends with the third
quarter of 1998. We use the mean absolute error (MAE) as an accuracy measure. As a bench-
mark, we use the simple average transition matrix of the past 56 quarters which is the uncondi-
tional transition matrix. Because each transition matrix has 56 elements, we assign the same
weight to all elements.6

Table 6 shows the ratio of our conditional approach’s MAE to the benchmark MAE. Our condi-
tional approach reduces forecasting errors by around 10% compared to the benchmark. Specif-
ically, our model provides better forecasts in the recent bull market than in the credit-crunch
period.

Table 6
Backtesting the conditional transition matrix
Sample Period MAE(Conditioanl/Unconditional)
Credit Crunch (1991–93) 1.0160
Bull Market (1994–97) 0.8534
Total Mean (1990–97) 0.9164

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How sensitive is credit loss simulation to the forecasted transition matrix? How much can the use
of a conditional transition matrix improve the accuracy of credit loss simulation in credit risk
models? To answer these questions, we analyze the credit loss simulation of an artificial portfolio
across the transition matrices provided by previous section.

The artificial portfolio is composed of exposures of 35 obligors whose ratings are distributed
across seven ratings on Moody’s scale. The face value of each exposure is equally set USD1MM

6
The sum of the each column of the transition matrix must be one. Thus, the number of independent ele-
ments is only 49.
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and the current value of the portfolio is USD 36,000,294. We use the quarterly realized, uncon-
ditional, and conditional transition matrices for the third quarter of 1998 in the previous
example. Since we set the analysis horizon for credit loss to one year, we convert all quarterly
transition matrices to annual transition matrices.

Chart 4 shows the distribution of credit value changes, as simulated by CreditMetrics.

Chart 4
Simulated distribution of credit value changes

0.030
Realized
Unconditional
0.025 Conditional

0.020
probability

0.015

0.010

0.005

0.000
36 36.5 37 37.5 38 38.5 39
value of credit portfolio (USD MM)

Compared to the distribution obtained from the unconditional transition matrix, the one
obtained from the conditional transition matrix matches better the distribution obtained from the
realized transition matrix as providing less credit loss by default and down-grade, and more
credit gain by up-grade during the next year.

To illustrate the tail distribution of credit value, Table 7 reports the 0.1th, 1st, 5th, and 10th
percentile loss from the mean portfolio value.

Table 7
Simulated percentile credit loss from mean
Loss from Mean (USD) Realized Unconditional Conditional
10th Percentile 435,179 838,090 (93) 626,528 (44)
5th Percentile 706,702 1,193,593 (69) 949,942 (34)
1st Percentile 1,267,950 1,996,528 (57) 1,617,276 (28)
0.1th Percentile 2,035,874 3,055,470 (50) 2,541,932 (25)

The numbers in parentheses provide the percent of deviation compared to the percentiles
obtained from the realized transition matrix. We can see a large difference in credit loss in the
tail, even with small changes in the transition matrix. Our conditional approach can reduce the
credit loss deviation of the unconditional approach by half. This shows how important is the
quality of the transition matrix for the accuracy of credit loss simulation and how important is
the stress testing of the transition matrix for credit risk management when the credit state
changes rapidly.
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&RQFOXVLRQ
Compared to the unconditional transition matrix used in current credit risk models, the condi-
tional transition matrix approach can improve the accuracy of the transition matrix. Furthermore
the accuracy of the transition matrix is critical for the accuracy of credit loss simulation in the
credit risk models. Also, the conditional transition matrix approach has a good stress-testing
feature. If an analyst has her own view of a macroeconomic change, she can easily build the
credit cycle index for the next quarter based on the estimated parameter, β̂ which represents
the relationship between the macroeconomic series and the credit cycle index. She can then
incorporate her own view of the credit cycle index into the transition matrix through the esti-
mated parameter γ̂ , which represents the sensitivity of the transition matrix to the credit cycle
index, and analyze the credit loss change of her portfolio.

5HIHUHQFHV
Basle Committee on Banking Supervision, 1999, Credit Risk Modelling: Current Practices and
Applications, BIS, Basle.

Belkin, Barry, Lawrence R. Forest, Jr., and Stephan Suchower, 1998, A One-parameter Repre-
sentation of Credit Risk and Transition Matrices, CreditMetricsTM Monitor, Third Quarter, JP
Morgan, New York.

Gupton, Greg M., Christopher C. Finger, and Mickey Bhatia, 1997, CreditMetricsTM - Technical
Document, JP Morgan, New York.

Maddala, G. S., 1983, Limited-Dependent and Qualitative Variables in Econometrics,

Cambridge university press, Cambridge.

Nickell, Pamela, William Perraudin, and Simone Varotto, 1998, Stability of Rating Transitions,
unpublished mimeo.

Wilson, Thomas, 1997, Portfolio Credit Risk, Risk 10 No. 9 and 10.