Credit Migration Matrices

This entry provides a brief overview of credit migration or transition matrices, which characterize past changes in credit quality of obligors (typically firms). They are cardinal inputs to many risk management applications, including portfolio risk assessment, the pricing of bonds and credit derivatives, and the assessment of regulatory capital as is the case for the New Basel Accord. I address questions of how to estimate these matrices, how to make inference and compare them, and provide two examples of their use: the pricing of a derivative called a yield spread option, and the calculation of the value distribution for a portfolio of credit assets. The latter is especially useful for risk management of credit portfolios.