TY - JOUR

T1 - A new approach to credit ratings

AU - Pertaia, Giorgi

AU - Prokhorov, Artem

AU - Uryasev, Stan

N1 - Funding Information: Helpful comments from Buhui Qiu and the participants of INFORMS 2019 and SEQURA 2019 are gratefully acknowledged. Research for this paper was supported by a grant from the Russian Science Foundation (Project No. 20-78-10113 ). Publisher Copyright: © 2021 Elsevier B.V.

PY - 2021/2/1

Y1 - 2021/2/1

N2 - Credit ratings are fundamental in assessing the credit risk of a security or debtor. The failure of the Collateralized Debt Obligation (CDO) ratings during the financial crisis of 2007-2008 and the massive undervaluation of corporate risk leading up to the crisis resulted in a review of rating approaches. Yet the fundamental metric that guides the construction of credit ratings has not changed. We study the inadequacies of the old metric in simple models of investment and in structured finance portfolio optimization tasks, and we propose a new methodology based on a buffered probability of exceedance. The new approach offers a conservative risk assessment, with substantial conceptual and computational benefits. We illustrate the new approach using several examples and report the results of a structuring step-up CDO case study, with details available in an online Supplement.

AB - Credit ratings are fundamental in assessing the credit risk of a security or debtor. The failure of the Collateralized Debt Obligation (CDO) ratings during the financial crisis of 2007-2008 and the massive undervaluation of corporate risk leading up to the crisis resulted in a review of rating approaches. Yet the fundamental metric that guides the construction of credit ratings has not changed. We study the inadequacies of the old metric in simple models of investment and in structured finance portfolio optimization tasks, and we propose a new methodology based on a buffered probability of exceedance. The new approach offers a conservative risk assessment, with substantial conceptual and computational benefits. We illustrate the new approach using several examples and report the results of a structuring step-up CDO case study, with details available in an online Supplement.

KW - Buffered probability of exceedance

KW - CDO

KW - CDS

KW - Collateralized debt obligation

KW - Conditional value at risk

KW - Credit Default Swap

KW - Credit rating

KW - CVaR

KW - Expected shortfall

KW - Loss given default

KW - Portfolio optimization

KW - Probability of exceedance

KW - Tranche structuring

KW - Value at risk

KW - VaR

UR - http://www.scopus.com/inward/record.url?scp=85103044218&partnerID=8YFLogxK

UR - https://www.mendeley.com/catalogue/e4ea0b09-ac55-3f8c-a8a5-afeab65787f2/

U2 - 10.1016/j.jbankfin.2021.106097

DO - 10.1016/j.jbankfin.2021.106097

M3 - Article

AN - SCOPUS:85103044218

JO - Journal of Banking and Finance

JF - Journal of Banking and Finance

SN - 0378-4266

M1 - 106097

ER -