Forecasting US bond default ratings allowing for previous and initial state dependence in an ordered probit model

In this paper we investigate the ability of a number of different ordered probit models to predict ratings based on firm‐specific data on business and financial risks. We investigate models which are based on momentum, drift and ageing, and compare them with alternatives which take the initial rating of the firm and its previous actual rating into account. Using data on US bond issuing firms, as rated by Fitch, over the years 2000 to 2007, we compare the performances of these models for predicting the ratings both in‐sample and out‐of‐sample using root mean squared errors, Diebold‐Mariano tests of forecast performance and contingency tables. We conclude that both initial and previous states have a substantial influence on rating prediction.