Abstract
This chapter reviews techniques for deriving risk-neutral transition matrices out of historical migration matrices and empirically observed credit spreads. The methods are illustrated by numerical examples using a simplified transition matrix with only three rating states. This chapter investigates how real-world or historical transition matrices can be transformed into risk-neutral ones. The former are rather used to determine Economic Capital or Value-at-Risk for credit portfolios. On the other hand, the use of the latter is rather to construct risk-neutral credit curves for different time horizons and adequately price credit derivatives. JLT define a methodology that can be used to value risky bonds as well as credit derivatives based on ratings allowing changes in credit quality before default.
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