Finding Generators for Markov Chains via Empirical Transition Matrices, with Applications to Credit Ratings

Abstract

In this paper we identify conditions under which a true generator does or does not exist for an empirically observed Markov transition matrix. We show how to search for valid generators and choose the “correct” one that is the most compatible with bond rating behaviors. We also show how to obtain an approximate generator when a true generator does not exist. We give illustrations using credit rating transition matrices published by Moody's and by Standard and Poor's.