Credit Rating Method

In efficient markets with rationally acting market participants, the price of a commodity is the result of all the information available to the participants, and is thus the best-possible estimate of the intrinsic value of the commodity. The credit ratings calculated on this basis thus represent the best possible result and show the market participants’ prognosis of the probability of a payment default by governments and companies.

System: the higher the expected earnings on an investment are, the larger are the risks involved. If the expected profits are compared against similar investment options, estimates on the probability of default can thus be derived from the capital market participants.

Reference: the level of yield on fixed interest loans traded on the stock exchange is used as a reference variable for measuring probabilities of default.

Basic principle: the higher the expected earnings of comparable investments are, the higher is the probability of default.

Adjustment: to establish comparability, it is necessary to adjust the heterogeneous selection of loans. A differing level of yield due to different issue currencies must also be balanced out, as is done with varying maturities by continually recalculating yield structure curves.

Scale: the rating scale applied is a relative, not an absolute, credit worthiness scale, and must be interpreted as an ordinal scale. Thus, issuers of an identical classification also have a comparable risk of payment default. The reference values of the scale are based on the global level of yield and must be recalculated continuously.

Rating codes: credit ratings and the resulting risk statements are expressed as a combination of letters and numbers and are comparable with the long-term credit ratings from renowned rating agencies.
The rating scale begins with "AAA 99" as the best-possible rating and is open-ended downward. Every rating class from "AAA" to "D" is divided into one hundred grades. For ratings below the rating class "D", numbers with a negative symbol are used.

Congruence: the comparability of loans is established by a mathematic process which balances issue currencies and maturities that differ due to heterogeneous loan markets. The principles are identical for all issuers and are free of any personal evaluations.

Credit rating: the expected earnings define the risk level at which capital market participants are willing to take a risk on the investment. By comparing the expected earnings of adjusted loans to each other, the credit ratings of the market participants are generated.

Reclassification: issuers can increase their credit worthiness if the yields of corresponding loans decrease more than the global level of yield; in turn, increasing yields have a negative impact on ratings.

Published in Issue 4 / 2013 of the magazine Kredit & Rating Praxis, the official organ of the Federal Association of Rating Analysts and Rating Avisors, e.V. (BdRA)