Transition Probability Matrix Methodology For Incremental Risk Charge
As part of Basel II's Incremental Risk Charge (IRC) methodology, this paper summarizes the authors' extensive investigations of constructing Transition Probability Matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. They highlight various aspects of three types of uncertainties embedded in different construction methods: the available historical data and the bank's rating philosophy; the merger of one-year Basel PD and the chosen Moody's TPMs; and deriving a monthly or quarterly TPM when the generator matrix does not exist.