A corporate bond portfolio manager was overhead asking:"Why do I need a credit risk model. I can get information about the probability of default from credit ratings?" How would you respond to this portfolio manager?
What will be an ideal response?
There are reasons for why one would want to use a credit risk model instead of simply relying on the probability of default from credit ratings. First, ratings are discrete with a limited number of rating grades. In contrast, default probabilities are continuous and range from 0% to 100%. Second, althoughratings are updated very infrequently, default probabilities can be estimated on a real-time basis. Van Deventer provides an example of the downgrade of Merck (from AAA to AA-) in 2004 . The downgrade came three weeks after the withdrawal of a major drug that significantly impacted Merck's stock price. Finally, there is no clear maturity for a credit rating. Althoughthere is a separate short- and long-term credit rating, credit risk models provide a default probability by maturity (i.e., a term structure of default probabilities). This provides insight into the default probabilities for different phases of the business cycle.
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