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The Journal of Structured Finance

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Credit Ratings, Default Probabilities, and Logarithms

Andre Cappon, Alexander Gorenstein, Stephan Mignot and Guy Manuel
The Journal of Structured Finance Spring 2018, 24 (1) 39-49; DOI: https://doi.org/10.3905/jsf.2018.24.1.039
Andre Cappon
is president of the CBM Group, LLC in New York, NY
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Alexander Gorenstein
is a consultant with the CBM Group, LLC in New York, NY
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Stephan Mignot
is a former managing director of the CBM Group, LLC in New York, NY
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Guy Manuel
is a former managing director of the CBM Group, LLC in New York, NY
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Abstract

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

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The Journal of Structured Finance: 24 (1)
The Journal of Structured Finance
Vol. 24, Issue 1
Spring 2018
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Credit Ratings, Default Probabilities, and Logarithms
Andre Cappon, Alexander Gorenstein, Stephan Mignot, Guy Manuel
The Journal of Structured Finance Apr 2018, 24 (1) 39-49; DOI: 10.3905/jsf.2018.24.1.039

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Credit Ratings, Default Probabilities, and Logarithms
Andre Cappon, Alexander Gorenstein, Stephan Mignot, Guy Manuel
The Journal of Structured Finance Apr 2018, 24 (1) 39-49; DOI: 10.3905/jsf.2018.24.1.039
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  • Article
    • Abstract
    • DEFAULT RATES INCREASE EXPONENTIALLY OVER RATING LEVELS
    • ESTIMATING DEFAULT PROBABILITIES WHERE DEFAULT STUDIES ARE ABSENT: CASE STUDY IN EMERGING MARKETS
    • APPLICATION TO BRAZILIAN BANKS
    • CONCLUSION
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