RT Journal Article
SR Electronic
T1 Credit Ratings, Default Probabilities, and Logarithms
JF The Journal of Structured Finance
FD Institutional Investor Journals
SP 39
OP 49
DO 10.3905/jsf.2018.24.1.039
VO 24
IS 1
A1 Andre Cappon
A1 Alexander Gorenstein
A1 Stephan Mignot
A1 Guy Manuel
YR 2018
UL https://pm-research.com/content/24/1/39.abstract
AB Analysis of rating agency global default studies reveals an interesting property of credit ratings: The logarithm of the probability of default is a linear function of the rating. On a semi-log chart, where the rating is on the horizontal axis and the probability of default on the vertical, the relationship is an upwardly sloping straight line. At any point on the rating scale, a rating downgrade by one rating category implies risk is approximately multiplied by a constant factor (around 3).These findings suggest credit ratings follow the so-called Weber–Fechner law of psychophysics, which states that the perception of a phenomenon is proportional to the logarithm of the underlying stimulus. Credit ratings are effectively perceptions of risk, behaving like other human perceptions. This property of credit ratings can be used to estimate probabilities of default when default studies are absent, incomplete, or insufficiently robust, as is often the case in emerging markets.TOPICS: Credit risk management, statistical methods