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APPRAISING CREDIT RATINGS: DOES THE CAP FIT BETTER THAN THE ROC?
Author(s) -
Irwin R. John,
Irwin Timothy C.
Publication year - 2013
Publication title -
international journal of finance and economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.505
H-Index - 39
eISSN - 1099-1158
pISSN - 1076-9307
DOI - 10.1002/ijfe.1471
Subject(s) - receiver operating characteristic , credit risk , econometrics , financial distress , independence (probability theory) , economics , probability of default , credit rating , actuarial science , statistics , mathematics , financial system
ABSTRACT Receiver operating characteristic (ROC) and cumulative accuracy profile (CAP) analyses are alternative methods for evaluating a wide range of diagnostic systems, including assessments of credit risk. The ROC analysis is widely used in many fields, but in finance, the CAP analysis is more common. We compare the two methods, by using as an illustration the ability of the Organization for Economic Cooperation and Development's country risk ratings to predict whether a country will have a programme with the International Monetary Fund (an indicator of financial distress). ROC and CAP analyses both have the advantage of generating measures of accuracy that are independent of the choice of diagnostic threshold, such as risk rating. The ROC analysis has other beneficial features, including theories for fitting models to data and for setting the optimal threshold, that we show could also be incorporated into the CAP analysis. But the natural interpretation of the ROC measure of accuracy and the independence of ROC curves from the probability of default are advantages unavailable to the CAP analysis. Copyright © 2013 John Wiley & Sons, Ltd.