Credit Ratings and Credit Risk: Is One Measure Enough?

Hilscher, Jens; Wilson, Mungo Ivor

doi:10.1287/mnsc.2016.2514

Cited by 152 publications

(73 citation statements)

References 63 publications

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“…Each month, from January 1992 to December 2012, we use the most recent SDR beta for each firm and sort the stocks 14 For robustness purposes, we follow Hilscher and Wilson (2013) and use the median PD as an alternative proxy for aggregate default risk. Hilscher and Wilson (2013) find that the median PD is highly correlated with the first principal component which explains the majority of variation in PDs across ratings. However, in our large sample of very heterogeneous countries, the median PD can be a rather noisy measure.…”

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confidence: 77%

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Pricing default risk: The good, the bad, and the anomaly

Filipe

Grammatikos

Michala

2016

Journal of Financial Stability

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While the empirical literature has often documented a "default anomaly", i.e. a negative relation between default risk and stock returns, standard theory suggests that default risk should be priced in the cross-section. In this paper, we provide an explanation for this apparent puzzle using a new approach. First we calculate monthly physical probabilities of default (PDs) for a large sample of European firms. Second we decompose these estimated PDs into systematic and idiosyncratic components; we measure the systematic part as the sensitivity of the physical PD to an aggregate measure of default risk. While sorting stocks based on physical PDs confirms a possible default anomaly, we find that the relation between the systematic default risk and stock returns is in fact positive. Our results therefore suggest that risker stocks, as measured by the physical PDs, will tend to underperform because they have on average lower exposures to aggregate default risk.Their riskiness is mostly idiosyncratic and can be diversified away. JEL Codes: G11, G12, G15, G33Keywords: Default Risk, Merton model, Default Anomaly, Idiosyncratic Risk * Luxembourg School of Finance, University of Luxembourg, 4 rue Albert Borschette, L-1246, Luxembourg. Emails: sara.ferreira@uni.lu; theoharry.grammatikos@uni.lu; dimitra.michala@uni.lu. Dimitra Michala is the corresponding author (Tel: +352 4666446805).We would like to thank Ali NasserEddine for excellent research assistance. This research is financially supported by the European Investment Bank University Research Sponsorship Program. All errors are our own. 1Finance theory suggests that, if default risk is systematic and thus non-diversifiable, it should be positively correlated with expected stock returns in the cross-section of firms. However, the empirical studies in the literature have delivered contradictory findings regarding the sign and significance of this relation. In this paper, we aim to bridge the gap between these seemingly puzzlingly results, by using a novel approach to study the relation between default risk and stock returns in Europe.Early studies show that small stocks have higher returns than big stocks (Banz, 1981, the so-called size effect) and that value stocks have higher returns than growth stocks (Fama and French, 1992, the so-called value effect). In line with theory, Chan and Chen (1991) and Fama and French (1996) suggest that size and book-to-market (BM) respectively proxy for a priced default risk factor. Validating this explanation, Vassalou and Xing (2004) and Chava and Purnanandam (2010) document a positive relation between default risk and stock returns in the US. In a recent working paper, Aretz, Florackis and Kostakis (2013) report similar findings using an international sample. On the contrary, several other studies find a negative relation between default risk and returns, the so-called "default anomaly". Examples are Dichev (1998), Griffin and Lemmon (2002), Campbell, Hilscher and Szilagyi (2008), Garlappi, Shu and Yan (2008), Avramov et a...

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confidence: 77%

“…Panel C of Table 5 reports the negative 12 The specification in (1) does not of itself constrain the PD to lie between zero and one. Hilscher and Wilson (2013) argue that this is not a problem, as long as most of the estimated PDs are small (so that (1 − ) ≈ ). Our estimated PDs satisfy this condition.…”

Section: A3 Vix and Aggregate Default Riskmentioning

confidence: 98%

Pricing default risk: The good, the bad, and the anomaly

Filipe

Grammatikos

Michala

2016

Journal of Financial Stability

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“…Such procedure may be justified on a number of grounds. In their paper, Hilscher and Wilson [16] provide a number of arguments which are not in favour of CRA ratings. Above all, even a very straightforward model developed by logistic regression, based on publicly available information and market indicators, remains superior in comparison to CRA ratings.…”

Section: Modification Of the Sa Approachmentioning

confidence: 99%

“…This can be interpreted as a response to increasing criticism of CRA ratings and their contribution to deepening the negative effects during periods of stress. It was proven that credit ratings are unable to predict the defaults in a proper manner and that they are inferior to the relatively straightforward scoring models which can be developed on the basis of publicly available information [16]. On the other hand, it was evident that certain manipulations had occurred, with respect to reallocation of portfolio in the classes which had been, in the eyes of regulators, perceived as less risky, and which were accordingly treated with lower risk weights.…”

Section: Introductionmentioning

confidence: 99%

The treatment of credit risk in post-crisis reform of Basel rules: Modification of the standardised and foundation IRB approach

Lazarević¹

2017

Ekonomika preduzeca

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SažetakOkvir za kreditne rizike Bazel II standarda nije uspeo na adekvatan način da pruži odgovor u uslovima krize zbog čega je neminovnost njegove revizije imperativ koji se postavlja pred Bazelski komitet. Sveobuhvatna reforma pristupa koji determinišu rizikom-ponderisanu aktivu u svom fokusu imaju upravo pravila vezana za kreditni rizik, jer je on njen najveći konstituent. Pravci evolucije pristupa za kreditni rizik naziru se iz konsultativnih dokumenata Bazelskog komiteta, i ovaj rad ima prvenstveno za cilj kritički osvrt na njihove nastupajuće promene sa primarnim aspektima na standardizovani pristup (SA) i osnovni IRB pristup (F-IRB). U tom smislu, apostrofirane su ključne tačke revizije i urađena je komparativna analiza u odnosu na trenutno aktuelnu regulativu. Kao dodatni benefiti istraživanja predstavljeni su predlozi koji treba da analitički nadograde aparaturu, posebno u delu F-IRB pristupa, gde su identifikovana pitanja korelacije, primene modela i njihove validacije. Jedno od zanimljivih rešenja koje se predlaže za unapređenje sistema kreditnih rizika bi predstavljao treći, hibridni pristup, koji bi podrazumevao konstrukciju modela od strane nacionalnih regulatora i primenu u njihovim jurisdikcijama. Dominantni zaključak celokupne evaluacije je potreba za radikalnim promenama okvira za kreditne rizike, jer su empirijske analize dokazale velike manjkavosti i anomalije obračuna rizikom-ponderisane aktive. Zbog toga se predlozi u konsultativnim dokumentima Bazelskog komiteta ne mogu smatrati korakom u pravom smeru jer je očigledna nedovoljna snaga za korenitim promenama pristupa koji se koriste za opisivanje pozicija izloženosti kreditnom riziku. AbstractThe framework for credit risk from Basel II standard failed to provide an adequate response in periods of crises, so the necessity of its revision is an imperative placed before the Basel Committee. A comprehensive reform of approaches used to determine risk-weighted assets is particularly focused on the rules relating to credit risk, because it is its largest constituent. The directions of evolution of approaches for credit risk can be anticipated in consultative documents of the Basel Committee, and this paper is primarily aimed at presenting a critical review of their upcoming changes, particularly focusing on Standardised approach (SA) and Foundation IRB approach (F-IRB). In that sense, key points of revision are emphasised, and comparative analysis regarding current regulations has been done. As additional benefits of research, certain suggestions are presented with a view to upgrading the architecture in an analytical sense, especially in the part relating to F-IRB approach, where correlation issues, application of models and their validation have been identified. One of interesting solutions proposed for improving the credit risk system would be the third hybrid approach, which implies the development of models by the national regulators and implementation in their jurisdictions. The dominant conclusion of the entire evaluation is the need for ...

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“…They found that firms with better CSR scores enjoy higher credit ratings from the same industry and geographical region. However, the use of credit ratings as a proxy for the probability-of-default is not appreciated due to its simplified approach based on publicly available information that does not include information on systematic risk and uncertainty (Hilscher & Wilson, 2013). Furthermore, the use of credit ratings as a proxy for credit risk not only reduces the number of observations but also does not take into consideration the dynamic nature of a firm's behavior over the period.…”

Section: Introductionmentioning

confidence: 99%