The effect of the number of states on the validity of credit ratings

Abstract: We explicitly test if the reliability of credit ratings depends on the total number of admissible states. We analyse open access credit rating data and show that the effect of the number of states in the dynamical properties of ratings change with time, thus giving supportive evidence that the ideal number of admissible states changes with time. We use matrix estimation methods that explicitly assume the hypothesis needed for the process to be a valid rating process. By comparing with the likelihood maximization method of matrix estimation, we quantify the "likelihood-loss" of assuming that the process is a well grounded rating process.