Credit Cycle Adjustment

Credit cycle adjustment is a tool commonly used in stress testing to force a change in credit migration based on macroeconomic conditions. The following illustrates the dynamics arising from applying these methodologies to S&Ps long run credit migration matrix. The calculation typically depends on:

• a base long run migration matrix (effectively the matrix when term equals 1 and cycle index equals 0 in the calculator below). The matrix from S&P used here uses all migrations from 1985 to 2024;

• an estimate of the cycle sensitivity of a portfolio, called the asset correlation captures the variation in default rates over time, some portfolios are significantly more sensitive than others. Technically the migration and default correlation are not equivalent;

• an estimate of the macroeconomic conditions as they affect credit, these estimates are often standardised to a cycle index which is a quantile of the normal distribution (with mean 0 representing mid cycle and a standard deviation of 1).

Methodology

• Trueck, Stefan and Emrah, Oezturkmen, Adjustment and Application of Transition Matrices in Credit Risk Models (September 2003). Available at SSRN: https://ssrn.com/abstract=675922 or http://dx.doi.org/10.2139/ssrn.675922

Data source

• Standard and Poors Default, Transition, and Recovery: 2024 Annual Global Corporate Default And Rating Transition Study.

Calculation

End state probability distribution depends on the term, cycle coniditions (Z, equivalent to a 1 in year ) and the Asset Correlation for years.

Cumulative migration matrix for years.

Evolution of cumulative probabilities of given a starting credit state of . Use the table above to select alternative starting credit states. Note that as the default state (D) is absorbing, given sufficient time regardless of the cycle index setting the default state will grow. The first 10 years illustrated here may not be sufficient to capture a significant increase in defaults if conditions are very good and sensitivity is very high.