Evolutionary optimization of transition probability matrices for credit decision-making

Abstract

Statistical transition probability matrices (TPMs), which indicate the likelihood of obligor credit state migration over a certain time horizon, have been used in various credit decision-making applications. A standard approach of calculating TPMs is to form a one-year empirical TPM and then project it into the future based on Markovian and time-homogeneity assumptions. However, the one-year empirical TPM calculated from historical data generally does not satisfy desired properties. We propose an alternative methodology by formulating the problem as a constrained optimization problem requiring satisfaction of all the desired properties and minimization of the discrepancy between predicted multi-year TPMs and empirical evidence. The problem is high-dimensional, non-convex, and non-separable, and is not effectively solved by nonlinear programming methods. To address the difficulty, we investigated evolutionary algorithms (EAs) and problem representation schemas. A self-adaptive differential evolution algorithm JADE, together with a new representation schema that automates constraint satisfaction, is shown to be the most effective technique.Risk management Finance Evolutionary computations Constraints satisfaction Decision support systems