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CDS-based implied probability of default estimation

Article in The Journal of Risk Finance · July 2020

DOI: 10.1108/JRF-05-2019-0079

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CDS-based
CDS-based implied probability of implied
default estimation probability
Amira Abid, Fathi Abid and Bilel Kaffel
Department of Management, Laboratory of Probability and Statistics,
Faculty of Business and Economic Sciences, University of Sfax, Sfax, Tunisia
Received 15 May 2019
Revised 28 September 2019
Abstract 23 March 2020
Accepted 8 June 2020
Purpose – This study aims to shed more light on the relationship between probability of default,
investment horizons and rating classes to make decision-making processes more efficient.
Design/methodology/approach – Based on credit default swaps (CDS) spreads, a methodology is
implemented to determine the implied default probability and the implied rating, and then to estimate the term
structure of the market-implied default probability and the transition matrix of implied rating. The term structure
estimation in discrete time is conducted with the Nelson and Siegel model and in continuous time with the
Vasicek model. The assessment of the transition matrix is performed using the homogeneous Markov model.
Findings – The results show that the CDS-based implied ratings are lower than those based on Thomson
Reuters approach, which can partially be explained by the fact that the real-world probabilities are smaller
than those founded on a risk-neutral framework. Moreover, investment and sub-investment grade companies
exhibit different risk profiles with respect of the investment horizons.
Originality/value – The originality of this study consists in determining the implied rating based on CDS
spreads and to detect the difference between implied market rating and the Thomson Reuters StarMine
rating. The results can be used to analyze credit risk assessments and examine issues related to the Thomson
Reuters StarMine credit risk model.
Keywords CDS, Market-implied default probability, Term structure, Implied rating,
Transition matrix
Paper type Research paper

1. Introduction
With the ever-growing evolution of the debt market, investors are increasingly focusing
on the credit risk related to transactions they wish to perform. The credit risk
assessment can be performed by estimating the default probability and, therefore, one
of the most important questions in the area of risk management is, what is the
probability that an entity will default on payment? This probability can be deduced
from the market data, or from the historical data provided by the rating agencies
(Merton, 1974; Jarrow, 2001; Hull et al., 2004). Some studies showed that credit default
swaps (CDS) spreads reflect information more precisely than credit rating and showed
the effectiveness of the CDS spread in the prediction of credit risk and that the default
probability withdrawn from the CDS spread is more real than the probability of default
withdrawn from other market data (Flannery et al., 2010; Dwyer et al., 2010; Cizel, 2013;
Jacobs et al., 2016; Rodriguez et al. (2019).
First, in this paper, we use the Hull (2014) model to calculate, from the CDS spreads, the
market-implied default probabilities that are then used to determine the studied companies’
ratings which are compared with ratings provided by Thomson Reuters StarMine model.
The Journal of Risk Finance
© Emerald Publishing Limited
1526-5943
JEL classification – G24, G32 DOI 10.1108/JRF-05-2019-0079
JRF In the credit risk management, investors are also interested in the relationship between
the probability of default, investment horizons and rating classes to achieve superior
returns. The term structure of the market-implied default probability and the implied rating
transition matrix are two important concepts in the management of credit risk, which give
an idea about the risk level for different horizons. In fact, they are two major indicators for
the market players to manage credit risk and make investment decisions. While the term
structure of the default probability calculated from the spread of CDS provides an accurate
way to study the relationship between the implied default probability and the debt contract
maturity, the rating transition matrix gives the probability that a company migrates from a
rating to another during a given period. In the field of estimating the term structure in
discrete time, the original Nelson and Siegel (1987) model is a convenient and parsimonious
exponential components framework which can replicate a variety of yield curve shapes
(Baranovski et al., 2009; Hua, 2015; Caldeiraa et al. (2016) Liu, 2017). In the field of estimating
the term structure in continuous time, the most recognized works in academic literature are
Vasicek (1977), Cox et al. (1985), Ho and Lee (1986) and Black et al. (1990).
Second, in this study, we assess the market-implied default probability term structure in
discrete and continuous time using the Nelson and Siegel (1987) model and Vasicek (1977)
model, respectively.
To predict the level of credit risk, the transition matrix is widely used in practice. This
consists in describing the dynamics of the credit risk in terms of transition probabilities
between the different qualities attributed by rating agencies. In this regard, Jarrow et al.
(1997) were the first to model the transition probabilities using the Markov chain on a finite
state-space that represented different rating classes. Since the work of these authors, the
Markov chain has been so popular in the estimation of rating transition matrices that it was
adopted by several researchers, such as Jones (2005), Frydman and Schuermann (2008),
Lando (2010), Engelmann and Ermakov (2011), Malik and Thomas (2012), Gavalas and
Syriopoulos (2014) and Blümke (2018). The homogeneous Markov chain model assumes
that, first, all credits have the same movement behavior among rating classes and their
behavior is the same over time. Second, the rating in the future depends only on the present
rating. However, there are many sources of heterogeneity in the rating behavior of which,
according to Frydman et al. (2004), the age of a bond is an important one. In fact, the
probability that a bond change rating, and in particular to default, is lower during the early
years after issuance than it is for the seasoned bond. These authors develop a model that
takes into account this heterogeneity called the mover–stayer model and the empirical
implementation of the model shows that the default probability of young corporate issuers,
estimated by this model, is lower than one estimated by the Markov chain model. Another
source of heterogeneity, considered by D’Amico et al. (2005) in their semi-Markov model, is
the duration inside a state. In fact, there is dependence of transition probabilities on the time
a company maintains the same rating. Pasricha et al. (2017) propose a model that addresses
the aging problem of credit rating evolution and assuming that the rating of a firm in the
future depends not only on its present rating but also on its previous ratings. They found
that if the present rating is lower than the previous one, there is a higher probability of
further downgrade in the future and they explained that by the momentum effect.
Finally, in this research, we predict the credit risk by estimating the implied rating
transition matrix using the homogeneous Markovian model developed by Jarrow et al.
(1997).
The determination of the market-implied default probability shows that it is positively
related to the CDS spread. This result corroborates the findings of Baranovski et al. (2009)
who obtained default probabilities from CDS spread for different rating classes and found CDS-based
that implied default probabilities and CDS spread evolve positively with maturity. implied
We find that regarding the implied rating, the studied companies are overvalued by
Thomson Reuters StarMine model compared to the CDS spread-based model. This can be
probability
explained by the fact that risk-neutral default probabilities are generally higher than real-
world default probabilities. In this context, Hull et al. (2005) find that the default probability
backed out from the bond’s price is higher than that calculated from historical data
published by Moody’s.
The term structure analysis reveals that, for any rating class, the market-implied default
probability increases with the maturity and with the degradation of the implied rating.
However, Trück et al. (2004) show that behaviors of the forward default probability and
CDS’ spread, with respect to time horizon, differ according to the class of the rating. They
suggest that the term structure of the forward default probability and that of the CDS’s
spread show a rising curve for the AAA, AA and A rating categories, a hump-shaped curve
for rating classes BBB, BB and B and a downward curve for CCC class, which also implies a
positive relationship between the spread of CDS and the default probability. That is why a
risk-averse investor would prefer investing in investment-grade companies rather than in
sub-investment companies both regarding the probability of default and the time horizon.
According to the arbitrage theory, the prediction results show that the risk of
degradation from one rating class to another is more important for the risk-neutral CDS-
implied rating than the Thomson Reuters StarMine implied rating.
The remainder of this paper is as follows. Section 2 presents the data and the
methodology. Section 3 provides an interpretation of the measurement and prediction
results. The paper ends with a summary of the main conclusions.

2. Data description and methodology

2.1 Data description
To measure and predict the credit risk, we use the CDS spreads and the Thomson Reuters
StarMine implied rating over the period extending from December 14, 2007 to June 14, 2016.
Data are shown for 16 US companies of various sectors. The choice of these companies was
made according to the same maturities of CDS contracts and the data availability. The CDS
spreads are daily, whereas the implied rating is annual. We worked on 6 months, 1, 2, 3, 4, 5,
7, 10, 20 and 30 years CDS maturities for each company. The data were obtained from the
Data Stream database. By observing the implied rating, given by the Thomson Reuters
StarMine model, of the surveyed companies during the study period, we found that 3M has
the highest ratings (AAA, AA, A) corresponding to a low credit risk. In fact, the 3M persists
and keeps its level of solvency even during the period of the financial crisis and then
declines only to BBB. However, the Hartford company has the lowest ratings (BBB, BB, B,
CCC) which correspond to a high credit risk. The 3M and Hartford companies will then
represent the investment grade and sub-investment grade classes, respectively. To display
credit rating evolution of these two companies in Figure 1, numbers from 1 to 8 are assigned
to the Thomson Reuters implied rating categories as shown in Table 1.
Figures 2 and 3 show the change over time in the CDS spreads for different maturities of
the two companies 3M and Hartford, respectively. There is an increase of the CDS
spread with the increase of maturity and a peak in 2009, which is more important for the
Hartford company; the CDS spreads of all the studied maturities reach their maximum in the
period from 2008 until 2010, corresponding to the period of the financial crisis. In the same
period, Figure 1 shows that the implied rating of these companies degrades, indicating an
JRF

Figure 1.
Thomson Reuters
implied rating
evolution of 3M and
Hartford companies

Table 1.
Thomson Reuters
(TR) implied ratings Rating code 1 2 3 4 5 6 7 8
and assigned
numerical coding TR-implied rating AAA AA A BBB BB B CCC CC

Figure 2.
CDS spreads
evolution of the 3M
investment grade
company for different
maturities

increase in the credit risk. The degradation is more important for Hartford, which means
that this company is more affected by the financial crisis.

2.2 Methodology
The methodology adopted in this paper is shown in Figure 4.
This methodology consists of three main steps. The first one aims at determining the
implied default probability and the implied rating of the companies. The second one is
devoted to estimating the implied default probability term structure in discrete and
continuous time based on the results derived in the first step. The third one is to predict the
risk level using the annual implied rating obtained in the first stage.
2.2.1 Market-implied default probability. In the first stage, from the observed CDS
spreads, we will determine the market-implied default probability by applying the Hull
(2014) model. The author started from the Hull and White (2000) model that determines the
CDS spread with a $1 notional principal and the default event can occur at any time without
taking into account the counterparty’s default risk to express the implied default CDS-based
probability. implied
This model assumes that default events, treasury interest rates and recovery rates are
mutually independent and that the claim in the event of default is the face value plus
probability
accrued interest. It is noted that T is the maturity of credit default swap, q(t) is the risk-
neutral default probability density at time t, R is the expected recovery rate on the
reference obligation in a risk-neutral world, u(t) is the present value of payments at the
rate of $1 per year on payment dates between time zero and time t, e(t) is the present value
of an accrual payment at time t equal to t
t* where t* is the payment date immediately
preceding time t, v(t) is the present value of $1 received at time t, w is the total payments
per year made by credit default swap buyer, s is the value of w that causes the credit
default swap to have a value of zero, p is the risk-neutral probability of no credit event
during the life of the swap and A(t) is the accrued interest on the reference obligation at
time t as a percentage of the face value. The value of p is one minus the probability that a
credit event will occur at time T.

ðT
p ¼1
qðtÞ (1)
0

The payments last until a credit event or until time T, whichever is sooner. If a default
occurs at time t (t < T), the present value of the payments is w[u(t) þ e(t)] and the expected
value of the reference obligation under the risk-neutral probability, as a percentage of the

Figure 3.
CDS spreads
evolution of the
Hartford sub-
investment grade
company for different
maturities

First stage:

CDS spreads default probability implied rating

Second stage:

Measure credit risk by estimating the term structure of market

implied default probability in discrete and continuous time

Figure 4.
Third stage: Methodology to
Predict credit risk level by estimating the implied rating transition assess and predict
matrix credit risk
JRF nominal value, is equal to (1 þ A(t))R. If there is no default prior to time T, the present value
of the payments is wu(T) and its expected value is equal to:

ðT
w qðtÞ½uðtÞ þ eðtÞdt þ wp uðT Þ (2)
0

The expected payoff from the CDS is:

1
½1 þ AðtÞR ¼ 1
R
AðtÞR (3)

Therefore, the present value of the expected payoff from the CDS is:

ðT
½1
R
AðtÞRqðtÞvðtÞdt (4)
0

and the value of the CDS for the buyer is the difference between the expected payoff and the
present value of the payments made by the buyer, so:

ðT ðT
½1
R
AðtÞRqðtÞvðtÞdt
w qðtÞ½uðtÞ þ eðtÞdt
wp uðT Þ (5)
0 0

The CDS spread, s, is the value of w that makes this expression zero:

ðT
½1
R
AðtÞRqðtÞvðtÞdt
0
s¼ (6)
ðT
½uðtÞ þ eðtÞqðtÞdt þ p uðT Þ
0

From the above equation, the following equation is deduced:

X
i ðtk  
qk 1
R
Ai ðtÞR vðtÞdt
k¼1
tk
1
si ¼ 2 3 (7)
X
i ðtk X
i
qk ½uðtÞ þ eðtÞdt þ uðti Þ41
qk ðtk
tk
1 Þ5
k¼1 k¼1
tk
1

The qi can be iteratively evaluated from this equation. It should be noted that d k = tk – tk–1,
ð tk ð tk ð tk
ak ¼ ½  ð Þ
1
R v t dt; b ki ¼ ð Þ ð Þ
Ai t Rv t dt; g k ¼ ½uðtÞ þ eðtÞdt
tk
1 tk
1 tk
1
 The default probability is written as: CDS-based
implied
X
i
1
 
si uðti Þ þ qk si g k
si uðti Þd k
ak þ b k;i probability
k¼1
qi ¼ (8)
ai
b i;i
si g i þ si uðti Þd i

Once the default probability is determined, on December 31 of each year during the study period,
the market-implied default probability with a maturity of one year will be used to determine the
studied companies’ ratings according to the classification defined by the Thomson Reuters
StarMine model. This model identifies the rating of a company depending on its default
probability backed out from the leverage, the volatility and the asset return. The model sets eight
intervals of default probabilities, for each one corresponding a different class of rating.
2.2.2 Term structure of default risk in discrete and continuous time. In the second stage,
the CDS-based default probability will be used to model the credit risk of the 3M and Hartford
companies in discrete and continuous time. The Nelson and Siegel (1987) model will be applied to
estimate in discrete time, first, the term structure of the market-implied default probability of the
3M and Hartford companies, and then the term structure of the average market-implied default
probability of each rating class according to the observed rating on the one hand and to the
determined rating on the other hand. This step gives us an idea about the relationship between
the market-implied default probability, the maturity and the implied rating.
In 1987, Nelson and Siegel proposed a model which enables to estimate the term structure
of the American Treasury bond spreads and predict their long-term prices. This model is
extensively used in the research studies as well as in practice through its parsimonious
structure which gives sufficient flexibility to reproduce different types of yield curve
(Annaert et al., 2013). By analogy with the bond spreads, the forward market-implied default
probability for T maturity, according to the Nelson and Siegel (1987) model, is:

T
qT ¼ b 1 þ b 2 e
t þ b e
t
T T
(9)
t 3
The function of the corresponding term structure is:
  T 

Tt

b 3 e
t
T
QT ¼ b 1 þ ð b 2 þ b 3 Þ 1
e = (10)
t

Diebold and Li (2006) reformulated the Nelson and Siegel (1987) equation so that parameters
( b 1, b 2 and b 3) can be easily interpreted. The forward default probability, according to
Diebold and Li (2006), is given by:

qt ðT Þ ¼ b 1t þ b 2t e
l t T þ b 3t l t e
l t T (11)

The function of the corresponding term structure is:

! !
1
e
l t T 1
e
l t T

Qt ðT Þ ¼ b 1t þ b 2t þ b 3t
e l t T
(12)
l tT l tT
JRF b 1t, b 2t and b 3t parameters can be considered as factors of level, slope and
curvature.
l tT

Their components are, respectively, a constant (1), a decreasing function of T 1
e l tT and a
1
e
l t T
l t T
concave function of T l tT
e . b 1t, b 2t and b 3t can be interpreted as being the
long-, short- and medium-term factors, respectively. b 1 is the long-term market-implied
default probability, where limT!1 qt(T) = b 1t. b 2t is the slope of the curve; if b 2t > 0, the
curve is downward, and if b 2t < 0, the curve is upward. The sum of b 1t and b 2t ( b 1t þ b 2t)
represents the initial value of the forward market-implied default probability, limT!0 qt(T) =
( b 1t þ b 2t) > 0. The parameter describing the curvature factor is b 3t. The b 3 sign gives
significance on the curve shape. It is a hump if b 3t > 0 and a trough if b 3t < 0. The absolute
value of b 3t indicates the hump or the trough size. The l t is a scale parameter or decreasing
parameter of market-implied default probability, which has a significant effect on the slope
and curvature components. For a very high value of l , the component of the slope decreases
slowly and the component of the curvature reaches its maximum afterwards. These
parameter interpretations are inspired by Nelson and Siegel (1987) and Diebold and Li
(2006).
The Vasicek (1977) model is a stochastic continuous model based on the specification of
the short rate process in a risk-neutral universe. According to Vasicek (1977), the short-term
market-implied default probability follows a process defined by the following stochastic
differential equation:

dqt ¼ að b
qt Þdt þ s dzt (13)

where dzt is a Wiener process and s determines the volatility of the market-implied default
probability. This model considers the mean reversion; indeed, the market-implied default
probability is pushed to its mean b with a rhythm defined by a. According to Vasicek
(1977), the term structure of the market-implied default probability is given by the following
equation:

1 1
Qðt; T Þ ¼
logð Aðt; T ÞÞ þ Bðt; T Þqt (14)
T
t T
t

where qt is the value of the short-term market-implied default probability at time t and A
and B are defined as follows:

1
e
aðT
tÞ
Bðt; T Þ ¼ (15)
a
 !
2
ð Bðt; T Þ
T þ tÞ a2 b
s2 s 2 Bðt; T Þ2
Aðt; T Þ ¼ exp
(16)
a2 4a

Equation (14) shows that the term structure of the market-implied default probability at time
t is a function of qt once a, b and s parameters are defined. Figures 5 and 6 illustrate the
evolution of the market-implied default probability of the 3M and Hartford companies, with
a maturity of 6 and 12 months, respectively, which are used to estimate the short-term
market-implied default probability process.
We notice that the curves peaked in 2009. The market-implied default probability of the
two studied companies increases and reaches its maximum in the period from 2008 to 2010
corresponding to the period of the financial crisis.
 2.2.3 Credit risk prediction. The third stage consists in predicting the risk level by CDS-based
estimating the one-year transition matrix of the Thomson Reuters StarMine implied rating implied
and of the CDS-implied rating by means of the homogeneous Markov model in discrete time.
The implied rating transition matrix, in our research, describes the risk dynamics in terms
probability
of transition probabilities between the various qualities assigned to the company by the
Thomson Reuters implied rating and the CDS-implied rating. A discrete-time Markov chain
is a stationary stochastic process that forms a series of random variables X1, X2. . .. . .Xn,
which are the company’s implied ratings in our case, with the results x1, x2. . .. . .xn.
A property of the Markov chain in discrete time is

PrðXnþ1 ¼ xnþ1 =X1 ¼ x1 ; X2 ¼ x2 ; . . . :; Xn ¼ xn Þ ¼ PrðXnþ1 ¼ xnþ1 =Xn ¼ xn Þ

(17)

The stationary distribution of a Markov chain with some transition matrix suppose that
over the long run, no matter the starting state was, the proportion of time the chain spends
in a particular state is approximately the same for all sates.
Therefore, the future implied rating at time t þ 1 depends only on the current implied
rating at time t. A dynamic follows a homogeneous Markov process if it is possible to
deduce the transition probabilities at horizon h(Ph) of the simple knowledge of one-year
transition probabilities (P). Therefore, we have

ph ¼ ph (18)

Figure 5.
Evolution of the
market-implied
default probability,
with 6 and 12 months
maturities, of the 3M
investment grade
company from 14/12/
2007 to 14/06/2016

Figure 6.
Evolution of the
market-implied
default probability,
with 6 and 12 months
maturities, of the
Hartford sub-
investment grade
company from14/12/
2007 to 14/06/2016
JRF Let N be the number of the possible implied ratings, M the transition matrix of one-year
individual implied rating and Pij the probability that the company may be in implied rating j
in (t þ 1), knowing that it is in implied rating i in t with Dt = 1 year.
2 3
P11 P12 P1N
6 P21 P22 P2N 7
6 7
M ¼6 6 7 (19)
7
4 5
PN1 P2N PNN

nij
pij ¼ (20)
ni

where nij is the number of times the company changes from implied rating i to implied rating j
during the study period and ni is the number of times the company is implicitly rated i during
XN
the study period. Given that p ¼ 1 for i = 1,2,. . .,N and Pij  0 V i, j = 1,2,. . ., N.
j¼1 ij
In this paper, implied ratings are identified according to the probability of default determined
from CDS spread and the classification defined by the Thomson Reuters StarMine model. Then,
the transition probabilities are estimated with the homogeneous Markov model.

3. Result analysis
3.1 Implied default probability and implied rating
The market-implied default probability is derived from the CDS’ spreads by means of
equation (3). As a result, for every company and every maturity, we will have a daily series
of market-implied default probabilities from 14/12/2007 to 14/06/2016. Figures 7 and 8 show
the market-implied default probability (qi) of the 3M and Hartford companies for different
maturities.
Figure 7.
Market-implied
default probability
evolution of the 3M
investment grade
company for different
maturities

Figure 8.
Market-implied
default probability
evolution of the
Hartford sub-
investment grade
company for different
maturities
Like the CDS spread, during the financial crisis period, the market-implied default CDS-based
probabilities reach their maximum, indicating that there is a positive relationship between implied
the CDS spread and the market-implied default probability. The increase of these two
measures implies the increase of the credit risk.
probability
On December 31 of each year, the market-implied default probability with a maturity of one
year will be used to determine the implied rating of companies according to the classification
defined by the Thomson Reuters StarMine model. So, for each company, we will have two
sequences; one consists of nine annual observed ratings and another one consists of nine annual
determined ratings. Then, the observed and determined ratings will be used to estimate the
average market-implied default probability for each rating class. Table 2 summarizes the
Thomson Reuters StarMine implied rating and determined CDS-implied rating.
Referring to Table 2, We notica that for each observation, determined ratings are different
from observed ratings. Companies are overvalued by the Thomson Reuters StarMine model
and are riskier when relying on the CDS-implied rating. This can be explained by the fact that
the default probabilities estimated by a real-world model are generally smaller than those of the
risk-neural model because the latter model considers all the risks that exist in the market
through the risk premium required by investors against the risk they assume.

3.2 Nelson and Siegel model results

The Nelson and Siegel (1987) model is strongly nonlinear; thus, it seems difficult to be
estimated (Annaert et al., 2013). To simplify the estimation procedure, it is necessary to
reduce the model to a linear regression model by fixing parameter l t, and then estimating
parameters b 1t, b 2t and b 3t by means of the (ordinary least squares) OLS method, as it is
recommended by Nelson and Siegel (1987), Diebold and Li (2006) and Annaert et al. (2013).
The l t selected parameter must correspond to the best estimation market-implied default
probabilities and to the maturity for which the value of the component of b 3t is the highest.
By referring to Muvingi and Kwinjo (2014), the estimation of the b 1t, b 2t and b 3t
parameters by means of OLS method will be realized by considering the following equation:

Qt ð T Þ ¼ X t * b t þ « t (21)

where Qt(T) is a vector of market-implied default probabilities at time t corresponding to n

maturities collected in vector T. b t is a vector of b 1t, b 2t and b 3t parameters. Xt is a vector
of b 1t, b 2t and b 3t parameters’ components. « t is a vector of error terms at time t for n
estimates of the market-implied default probabilities. Vector Xt is the vector of the
independent variables that explain the dependent variables of vector Qt(T). According to the
Nelson and Siegel (1987) model, the Xt vector is:
2 ! 3
1
e
l t T1 1
e
l t T1
61
e t 1 7

l T
6 l t T1 l t T1 7
6 ! 7
6 7
6 1
e
l t T2 1
e
l t T2 7
6
Xt ¼ 6 1
e
l t T2 7 (22)
T T 7
6 l t 2 l t 2
!7
6 7
6 1
e
l t Tn 1
e
l t Tn 7
4 5
1
e
l t Tn
l t Tn l t Tn

The parameters estimated through the OLS method are given by:
 JRF

Table 2.

implied rating
determined CDS-
Reuters StarMine
implied rating and
Observed Thomson
Date 31/12/2007 31/12/2008 31/12/2009 31/12/2010 31/12/2011 31/12/2012 31/12/2013 31/12/2014 31/12/2015

Rating TR CDS TR CDS TR CDS TR CDS TR CDS TR CDS TR CDS TR CDS TR CDS
Cisco Systems A BB BBB CCC A BB BBB BB BBB BB A BB A BBB AA BBB A BBB
Coca Cola AAA BB A BB AA BB AAA BB AA BB AA BB AAA BBB AA BBB AA BBB
DuPont de Nemours A BBB BB CCC BB B BBB BBB BBB BBB BBB BBB A BBB A BBB BBB BB
3M AA BBB BBB CCC A BB A BB A BBB AA BBB AAA BBB AA A AA BBB
AT&T A BB BB B BBB BB A BB A BB A BB A BBB A BBB A BB
Boeing A BB B CCC BB BB BBB B BBB BB A BB A BBB A A A BBB
Chevron AA BB BB CCC A BB A BBB A BBB A AA AA BBB A BB BBB BB
Cigna A B B CCC BB B BBB BB BBB BB A BB A BBB A BBB A BBB
Hartford BBB BB CCC CC CCC CCC B B B B BB B BBB BB BBB BB BBB BBB
Home Depot BBB B BBB CCC BBB B A BB A BBB AA BBB AA BBB AA A AA A
Humana A BB B CC BB CCC BBB B BBB B BBB B A BB A BB A BBB
Johnson & Johnson AAA BBB A BBB AA BB AAA BB AA BBB AAA BBB AAA A AAA BBB AAA BBB
Microsoft AA BBB BBB BB A BB A BB A BB AA BB AA BB AA A A BBB
Procter and Gamble AAA BB A CCC A BB AA BB AA BB AA BB AA A AAA A AA BB
Verizon Communication A BBB BB CCC BBB BB A BB A BB A BB A BBB A BB A B
Walmart Stores A BB A CCC A BB AA BB AA BB AA BB AA A AA BBB A BBB

1
b^ OLS ¼ ð X T X Þ X T Q (23) CDS-based
implied
where b ^ OLS is the vector parameters of dimension k, X = (vX1X2. . .Xk–1) is constituted by probability
vector v and the independent variables, v is a vector of n dimension and contains ones and X
is a vector of nk dimension. The estimated vector of market-implied default probabilities can
be obtained from the estimated vector of parameters b^ OLS as follows:

^ ¼ X b^
Q (24)
OLS

The estimated parameters ( b ^ 1t , b^ 2t and b^ 3t ) and the fixed value of l t, for each estimation
date (t), for the two 3M and Hartford companies are summarized in the Tables 3 and 4.
We notice that the estimated parameters are significant at 1% risk level. Moreover, we
notice that coefficient b ^ 2t for Hartford company, in absolute value, is strictly greater than
that of 3M company at each estimation date. As a result, the slope of the term structure
curve for the Hartford company is expected to be stronger than that of the 3M company.
The observed term structures of the market-implied default probability and those
estimated by the Nelson and Siegel (1987) model are shown in Figure 9.
Figure 9 shows that the curve of the estimated term structure coincides with the
observed one, which implies that the Nelson and Siegel (1987) model is performing well in
the prediction of the long-term market-implied default probability. The term structure of the
market-implied default probability of the Hartford sub-investment grade company is higher
than that of the 3M investment grade company, which implies that for each maturity, the
implied default probability of Hartford is higher than that of 3M. The term structure of the
market-implied default probability shows a rising curve, which indicates that the long-term
default risk is more important than the short-term one. Then, a risk-averse investor has an
interest in investing in these two companies in the short term rather than in the long term. It
is also observed that the slope of the curve corresponding to Hartford is stronger than that of
3M, which means that the market-implied default probability of the sub-investment grade
class increases at a greater rate than that of the investment grade class, especially in a period
of crisis. Indeed, a very significant increase of the market-implied default probability is
observed in 2008 when it exceeded 80% for Hartford and 40% for 3M for a 30-year maturity,
whereas, in 2007, it was close to 20% for both companies.
The Nelson and Siegel (1987) model is applied also to estimate the term structures of the
average market-implied default probability of the observed and determined rating classes.
The estimated [1] term structures on December 31, 2007, 2008 and 2015 are presented in
Figure 10:
From Figure 10, it can be noted that the term structure corresponding to a higher quality
rating class is below the one corresponding to a lower quality rating class, which indicates
that the average market-implied default probability increases with the degradation of the
rating. The market-implied default probability is, in fact, positively related to the maturity
and negatively to the rating, which is in line with the results of Trück et al. (2004) and
Muvingi and Kwinjo (2014).

3.3 Vasicek model results

The parameter estimation of the Vasicek (1977) model through the maximum likelihood
estimation (MLE) method consists in estimating the parameters that maximize the
likelihood function. Considering N observations of market-implied default probabilities with
maturities 6 and 12 months, the likelihood function is as follows:
 JRF

company
Table 3.
Estimated

model for the 3M

parameters of the
Nelson and Siegel
Date b^ 1t (p-value) b^ 2t (p-value) b^ 3t (p-value) lt

31/12/2007 0.4395853 (8.93e
16***)
0.4394233 (4.61e
16***)
0.4278733 (1.66e
13***) 0.09692446

31/12/2008 0.8909919 (3.49e
11***)
0.8834829 (1.79e
11***)
0.5605898 (1.75e
07***) 0.1055055
31/12/2009 0.6318596 (5.96e
12***)
0.6335368 (3.33e
12***)
0.5273595 (2.11e
09***) 0.08540015
31/12/2010 0.553917 (1.69e
12***)
0.5545235 (8.29e
13***)
0.5007607 (6.33e
10***) 0.1024773
31/12/2011 0.6506861 (4.25e
12***)
0.6511814 (1.91e
12***)
0.6068704 (1.92e
09***) 0.1157048
31/12/2012 0.5702101 (5.63e
12***)
0.5713426 (2.51e
12***)
0.5607606 (1.76e
09***) 0.1157048
31/12/2013 0.5875775 (1.95e
12***)
0.5850175 (8.71e
13***)
0.6454171 (3.52e
10***) 0.1236869
31/12/2014 0.6134296 (2.38e
12***)
0.6102621 (1.07e
12***)
0.6860592 (3.79e
10***) 0.1236869
31/12/2015 0.6278709 (2.19e
12***)
0.6244513 (9.88e
13***)
0.6896249 (3.97e
10***) 0.1236869

Note: ***Denotes a 1% level of significance

Date b^ 1 (p-value) b^ 2 (p-value) b^ 3 (p-value) l

31/12/2007 0.65690 (2.36e
08***)
0.65931 (1.68e
08***)
0.42505 (1.42e
05***) 0.05976451

31/12/2008 1.01004 (1.90e
07***)
0.90895 (1.96e
07***) 0.35754 (0.0119*) 0.1434436
31/12/2009 1.023201 (2.67e
11***)
1.028068 (1.06e
11***)
0.6859315 (2.39e
07***) 0.1434436
31/12/2010 1.04674 (2.15e
10***)
1.05984 (8.42e
11***)
0.56329 (5.69e
06***) 0.1280884
31/12/2011 1.10862 (2.84e
12***)
1.10378 (1.70e
12***)
0.72242 (1.21e
07***) 0.2241687
31/12/2012 0.96148 (9.92e
11***)
0.97403 (3.72e
11***)
0.73951 (4.39e
07***) 0.1559174
31/12/2013 0.856244 (9.44e
12***)
0.859709 (3.77e
12***)
0.833303 (8.41e
09***) 0.1559174
31/12/2014 0.815439 (2.15e
11***)
0.817681 (8.65e
12***)
0.812353 (1.62e
08***) 0.1559174
31/12/2015 0.744000 (1.87e
11***)
0.745852 (7.53e
12***)
0.747693 (1.01e
08***) 0.1434436

Note: *** and *denote a level of significance of 1% and 10%, respectively

Nelson and Siegel

Estimated
Table 4.
probability
implied
CDS-based

Hartford company
model for the
parameters of the
JRF

Figure 9.
Observed and fitted
market-implied
default probability
term structures of the
3M investment grade
company and the
Hartford sub-
investment grade
company on
December 31, 2007,
2008, 2011, 2012
and 2015

Y
N
1
 
Lðu Þ ¼ P qtiþ1 =qti ; u ; Dt (25)
i¼1

where Dt is the time interval, u is the vector of the (a, b and s ) parameters to be estimated
and P is the density function of the Vasicek (1977) model. The log-likelihood function is:

X
N
1
 
lnLðu Þ ¼ lnp qtiþ1 =qti ; u ; Dt (26)
i¼1
 CDS-based
implied
probability

Figure 10.
Fitted term structures
of the average
market-implied
default probability of
each rating category
provided by the
Thomson Reuters
StarMine model and
by the CDS implied
rating, on December
31, 2007, 2008
and 2015

The density function of the Vasicek (1977) model is given by the following equation:
0  1
2
  1 @ qti þ1
qti e
aDt

b ð 1
e
aDt Þ
A
p qti þDt j qti ;u ;Dt ¼ pffiffiffiffiffiffiffiffiffiffiffiffi exp
(27)
2p s ^ 2 2s^ 2

where
1
e
2aDt
s^ 2 ¼ s 2 (28)
2a
The corresponding log-likelihood function is:
l ðu Þ ¼ lnLðu Þ
N
1 h i2
N
1 N
1 1 X
¼
lnð2p Þ
lnðs
^Þ
2 qti þ1
qti e
aDt
b ð1
e
aDt Þ
2 2 ^ i¼1
2s
(29)
JRF The maximum likelihood estimator u^ of parameters vector u is:
 
u^ a ^ ;s
^; b ^ ¼ argmaxð lnLðu ÞÞ (30)

The estimation results are reported in Table 5.

We notice that all estimated parameters are significant. Besides, a very high mean
reversion speed (parameter alpha) which is superior to one for 3M and superior to three
for Hartford is found. We therefore expect a fast mean reversion of the term structure of
the market-implied default probability. Hartford’s estimation results show that the mean
reversion speed and the volatility are very high, indicating that the company is in a phase
of value destruction. Therefore, very high values of a and s describe the pattern of the
sub-investment grade company. Figure 11 shows the term structure of the market-
implied default probability.
We note that the slope of the term structure is very strong, reflecting the high value of the
mean reversion speed at which the default probability is pulled to its average long-term
level. Therefore, the market-implied default probability cannot remain close to its current
levels.

3.4 Rating transition matrix results

To assess the implied rating transition, the Bootstrap maximum likelihood method is
applied. This method includes the three steps. The first step is the application of the
bootstrap technique on an annual implied rating sequence. The number of the bootstrap
samples is 10. The second step is the use of the MLE method on every sample bootstrap
separately. Let us assume that t0, t1,. . ..,tn are discrete time points with a time interval Dt

Table 5.
Parameter estimation
of the Vasicek model
3M Hartford
for 3M investment
Parameters Estimated values p-Values Estimated values p-Values
grade company and
Hartford sub- a 1.0171 0.0000 3.0857 0.0000
investment grade b 0.0030 0.0000 0.0263 0.0000
company s 0.0701 0.0000 0.8528 0.0000

Figure 11.
Vasicek term
structure of the
market-implied
default probability of
the 3M investment
grade company and
the Hartford sub-
investment grade
company
equal to one year. As described by Christensen et al. (2004), the MLE of the transition CDS-based
probability is given by the following equation: implied
X
N
1 probability
nij ðDtk Þ
^p ij ¼ k¼0
(31)
X
N
1
ni ð t k Þ
k¼0

where nij(Dtk) is the number of times the company changes from implied rating i to implied
rating j during the Dtk time interval, and ni(Dtk) is the number of times the company would
be in implied rating i during the Dtk interval.
The estimation of transition probabilities is the third step. The estimated transition
probability from implied rating i to implied rating j (^p ij ) is the average of (^p ij ) of the
bootstrap samples. The log likelihood of the transition matrix estimation is as follows:
X 
LLH ¼ log ^p ij (32)
ij

The standard error of the transition probability estimation is:

^p ij
SEij ¼ pffiffiffiffiffi (33)
nij

The one-year implied rating transition matrices, the confidence interval and the standard
error for each transition probability are summarized in Tables 6–9.
According to these tables, the estimated transition probabilities belong to the
corresponding confidence intervals with low standard errors of estimation for a confidence
level of 95%. We notice that, after one year, the 3M company, which has the Thomson
Reuters implied rating AA (CDS-implied rating BBB) on December 31, 2015, has a
probability of 0.382 (0.492) to improve and becomes AAA (A), a probability of 0.492 (0.233)
to stay in the same class of rating and 0.127 (0.275) to degrade and become BBB (CCC). The
Hartford company, which is rated BBB at the end of 2015 by the Thomson Reuters implied
rating (BBB by the CDS-implied rating), can keep the same rating class with a probability of
0.605 (0.083), as it may degrade and become B or CCC (CCC or CC) with a probability of 0.033
and 0.362 (0.033 and 0.883), respectively. We therefore note that with the CDS-implied rating,
the risk of degradation is more important than with the Thomson Reuters implied rating
and the both companies have the same class rating (BBB) on 31/12/2015. In addition, an
investor has interest in investing in investment grade company because, after one year, the
latter has the opportunity to improve its rating and its degradation probability is low
compared to that of sub-investment grade company.

4. Conclusion
Measuring and predicting the default risk by modeling the term structure of the market-
implied default probability and estimating the one-year transition matrix of implied rating
were the main objectives of this work. In fact, we studied the credit risk of the 3M and
Hartford companies which represent the investment and sub-investment grade rating
classes, respectively. First, the market-implied default probability is calculated from the
JRF CDS spreads using the Hull model. This probability was used to determine the rating
according to the classification defined by the Thomson Reuters StarMine model. By
comparing the ratings issued by this last model to the risk-neutral model based on CDS
spreads, it has been found that companies are overvalued by Thomson Reuters StarMine
model and are riskier when relying on the CDS-implied rating. Then, we estimated the term
structure of the market-implied default probability in discrete and continuous time using the
Nelson and Siegel and Vasicek models, respectively, and then we predicted the one-year

Implied rating AAA AA A BBB

AAA 0.0 0.8 0.2 0.0

(0.0*) (0.133*) (0.133*) (0.0*)
(0.0**) (0.581**) (0.0**) (0.0**)
(0.0***) (1.0***) (0.420***) (0.0***)
AA 0.382 0.492 0.0 0.127
(0.1*) (0.072*) (0.0*) (0.051*)
(0.217**) (0.373**) (0.0**) (0.042**)
Table 6. (0.547***) (0.610***) (0.0***) (0.211***)
One-year transition A 0.0 0.607 0.393 2.641e
316
matrix of Thomson (0.0*) (0.118*) (0.118*) (0*)
Reuters implied (0.0**) (0.412**) (0.199**) (2.641e
316**)
rating estimated by (0.0***) (0.801***) (0.588***) (2.641e
316***)
the discrete-time BBB 3.274e
316 0.0 1 0.0
homogeneous (0.0*) (0.0*) (0.102*) (0.0*)
(3.274e
316**) (0.0**) (0.833**) (0.0**)
Markov model for
(3.274e
316***) (0.0***) (1***) (0.0***)
3M investment grade
company on 31/12/ Notes: Level of confidence: 95%; *standard error; **lower end of the confidence interval; ***upper end of
2015 the confidence interval

Implied rating A BBB BB CCC

A 0.163 0.737 0.0474 0.052

(0.103*) (0.153*) (0.030*) (0.05*)
(0.0**) (0.485**) (0**) (0**)
(0.333***) (0.988***) (0.097***) (0.135***)
BBB 0.492 0.233 0 0.275
(0.088*) (0.055*) (0*) (0.07*)
(0.346**) (0.142**) (0**) (0.159**)
Table 7. (0.637***) (0.324***) (0***) (3.907***)
One-year transition BB 0.0 0.683 0.317 2.21e
316
matrix of CDS- (0.0*) (0.091*) (0.09*) (0*)
implied rating (0.0**) (0.533**) (0.167**) (2.21e
316**)
estimated by the (0.0***) (0.833***) (0.466***) (2.21e
316***)
discrete-time CCC 0.05 0.056 0.894 1.7e
316
homogeneous (0.03*) (0.05*) (0.133*) (0.0*)
(0.0005**) (0.0**) (0.674**) (1.7e
316**)
Markov model for
(0.1***) (0.138***) (1.0***) (1.7e
316***)
3M investment grade
company on 31/12/ Notes: Level of confidence: 95%; *standard error; **lower end of the confidence interval; ***upper end of
2015 the confidence interval.
implied rating transition matrix. The Nelson and Siegel model has also been used to CDS-based
estimate the term structure of the average market-implied default probability of each rating implied
class, after ranking the companies, according to the Thomson Reuters implied rating
categories on the one hand, and to the CDS-implied rating on the other hand, at given dates.
probability

Implied rating BBB BB B CCC

BBB 0.605 0.0 0.033 0.362

(0.079*) (0.0*) (0.033*) (0.088*)
(0.476**) (0.0**) (0.0**) (0.217**)
(0.734***) (0.0***) (0.088***) (0.506***)
BB 0.917 0.083 0.0 0.0
(0.083*) (0.083*) (0.0*) (0.0*)
(0.779**) (0**) (0.0**) (0.0**) Table 8.
(1.0***) (0.22***) (0.0***) (0.0***) One-year transition
B 0.0 0.815 0.185 0.0 matrix of Thomson
(0.0*) (0.1175*) (0.086*) (0.0*) Reuters implied
(0.0**) (0.622**) (0.044**) (0.0**) rating estimated by
(0.0***)) (1***) (0.327***) (0.0***) the discrete-time
CCC 0.0 0.0 0.525 0.475 homogeneous
(0.0*) (0.0*) (0.093*) (0.088*) Markov model for
(0.0**) (0.0**) (0.372**) (0.33**)
Hartford sub-
(0.0***) (0.0***) (0.678***) (0.62***)
investment grade
Notes: Level of confidence: 95%; *standard error; **lower end of the confidence interval; ***upper end of company on
the confidence interval 31/12/2015

Implied rating BBB BB B CCC CC

BBB 0.083 0.0 0.0 0.033 0.883

(0.057*) (0.0*) (0.0*) (0.033*) (0.079*)
(0.0**) (0.0**) (0.0**) (0.0**) (0.754**)
(0.177***) (0.0***) (0.0***) (0.088***) (1.0***)
BB 0.6 0.3 0.0 2.021e
312 0.1
(0.125*) (0.11*) (0.0*) (0.0*) (0.1*)
(0.395**) (0.118**) (0.0**) (2.021e
312**) (0.0**)
(0.8055***) (0.482***) (0.0***) (2.021e
312***) (2.645e
01***)
B 0.0 0.425 0.575 6.027e
312 0.0
(0.0*) (0.087*) (0.087*) (0.0*) (0.0*)
(0.0**) (0.281**) (0.431**) (6.027e
312**) (0.0**) Table 9.
(0.0***) (0.569***) (0.719***) (6.027e
312***) (0.0***) One-year transition
CCC 0.0 0.0 1.0 3.049e
312 9.041e
312 matrix of CDS-
(0.0*) (0.0*) (0.123*) (0.0*) (0.0*) implied rating
(0.0**) (0.0**) (0.797**) (3.049e
312**) (9.041e
312**) estimated by the
(0.0***) (0.0***) (1***) (3.049e
312***) (9.041e
312***) discrete-time
CC 0.0 0.0 0.555 0.444 0.0 homogeneous
(0.0*) (0.0*) (0.167*) (0.163*) (0.0*) Markov model for
(0.0**) (0.0**) (0.281**) (0.176**) (0.0**)
Hartford sub-
(0.0***) (0.0***) (0.830***) (7.13e
01***) (0.0***)
investment grade
Notes: Level of confidence: 95%; *standard error; **lower end of the confidence interval; ***upper end of company on
the confidence interval 31/12/2015
JRF The term structure of the market-implied default probability estimated in discrete time
shows that the investor has an interest in investing in investment and sub-investment grade
companies for short horizon times. The estimation of the term structure of the average
market-implied default probability of each rating class shows that the average market-
implied default probability is negatively related to the implied rating. Moreover, the term
structure slope of the market implied default probability of the sub-investment grade class is
stronger than that of the investment grade class, especially in a period of crisis. The term
structure of the market-implied default probability estimated in continuous time reveals a
fast mean reversion, which implies that the market-implied default probability does not
move away from its equilibrium level for a long time. Finally, the estimation of the one-year
transition matrices of the Thomson Reuters and CDS-implied rating, for 3M investment
grade company and Hartford sub-investment grade company, shows that the risk of
degradation from one rating class to another is more important for the CDS-implied rating
than the Thomson Reuters model and the investor has interest in investing in investment
grade company.

Note
1. The tables of estimated parameters of the Nelson and Siegel (1987) model for each rating class
are available upon request.

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Further reading
Caldeiraa, J.F., Moura, G.V., Santos, A.A.P. and Tourrucôo, F. (2016), “Forecasting the yield curve with
the Arbitrage-Free dynamic Nelson–Siegel model: Brazilian evidence”, EconomiA, Vol. 17 No. 2,
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application to bond ratings migration”, Applied Stochastic Models in Business and Industry,
Vol. 20 No. 2, pp. 155-170.
Rodríguez, I.M., Dandapani, K. and Lawrence, E.R. (2019), “Measuring sovereign risk: are CDS spreads
better than sovereign credit ratings?”, Financial Management, Vol. 48 No. 1, pp. 229-256.

Corresponding author
Amira Abid can be contacted at: abidamira1987@gmail.com

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