Determining a credit transition matrix from cumulative default probabilities

Abstract: To quantify the changes in the credit rating of a bond is an important mathematical problem for the credit rating industry. To think of the credit rating as the state a Markov chain is an interesting proposal leading to challenges in mathematical modeling. Since cumulative default rates are more readily measurable than credit migrations, a natural question is whether the credit transition matrix (CTM) can be determined from the knowledge of the cumulative default probabilities. Here we use a connection between the CTM and the cumulative default probabilities to setup an ill-posed, linear inverse problem with box constraints, which we solve by an entropy minimization procedure. This approach is interesting on several counts. On the one hand, we may have less data that unknowns, and on the other hand, even when we have as much data as unknowns, the matrix connecting them may not be invertible, which makes the problem ill-posed. Besides developing the tools to solve the problem, we apply it to several test cases to check the performance of the method. The results are quite satisfactory.