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Chapter 4: Prediction of Default and Transition Rates

4

Prediction of Default and Transition Rates

Default and transition rates are essential to pricing or risk management. Based on a forecast for next year's default rate, for example, a bank can set appropriate loan rates for short-term loans.

In Chapter 3, we showed how to estimate average transition rates based on data extending over several years. If such rates are used to estimate next year's transition rates, one would implicitly assume the next year to be a typical or average year. Although this may be an appropriate assumption in some situations, in others we may have good reason to believe that the following year should be relatively good or bad for credits. If the economy is just moving into a recession, for example, we should expect default rates to be relatively high.


  

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