Contingent Claims Analysis Applied in Credit Risk Modeling

Abstract

A fundamental in credit risk analysis is estimation of the probability that fixed-income securities will migrate to different bond rating categories. Unlike historical transition probabilities, several contingent claims credit risk methodologies simulate the value of a firm's assets and/or debt ratio to create bond rating probability distributions. This study tests the validity of using empirically calculated debt ratios to assign bond ratings. The empirical tests provide evidence supporting the use of such methodologies, with some caveats. Debt ratios are industry-specific and time-dependent, so care must be taken in estimating model parameters from historical relationships.