Buffered Probability of Exceedance (bPOE) Ratings for Synthetic Instruments

Abstract

Credit Rating is an important characteristic of company in financial market. Investors determine the appropriate yields (required return) for the assets such as Bonds and CDO tranches, based on credit rating. Current methodology for measuring credit rating for synthetic instruments is based on probability of exceedance concept. The probability of exceedance has several drawbacks as a measure of risk. The most important is that it does not measure the magnitude of loss in the event of default. Therefore, financial instruments with very different exposures in the event of default may have the same rating. This paper illustrates, how the new measure called Buffered Probability of Exceedance (bPOE) can be used to calculate the credit ratings. The bPOE has exceptional qualitative and quantitative characteristics, compared to the probability of exceedance. bPOE is sensitive to the thickness of the tail of the loss distribution. Therefore, the exposure in the event of default impacts the ratings based on bPOE.