Innovative transition matrix techniques for measuring extreme risk: an Australian and U.S. comparison

Abstract

Comparing Australia and the U.S. both prior to and during the Global Financial Crisis (GFC), using a dataset which includes more than six hundred companies, this paper modifies traditional transition matrix credit risk modelling to address two important issues. Firstly, extreme credit risk can have a devastating impact on financial institutions, economies and markets as highlighted by the GFC. It is therefore essential that extreme credit risk is accurately measured and understood. Transition matrix methodology, which measures the probability of a borrower transitioning from one credit rating to another, is traditionally used to measure Value at Risk (VaR), a measure of risk below a specified threshold. An alternate measure to VaR is Conditional Value at Risk (CVaR), which was initially developed in the insurance industry and has been gaining popularity as a measure of extreme market risk. CVaR measures those risks beyond VaR. We incorporate CVaR into transition matrix methodology to measure extreme credit risk. We find significant differences in the VaR and CVaR measurements in both the US and Australian markets, as CVaR captures those extreme risks that are ignored by VaR. We also find a greater differential between VaR and CVaR for the US as compared to Australia, reflecting the more extreme credit risk that was experienced in the US during the GFC.