The Regime-Switching Structural Default Risk Model

54 Pages Posted: 19 Sep 2011 Last revised: 15 Jan 2024

See all articles by Andreas Milidonis

Andreas Milidonis

University of Cyprus - Department of Accounting and Finance

Kevin Chisholm

Independent

Date Written: January 12, 2024

Abstract

We develop the regime-switching default risk (RSDR) model as a generalization of Merton’s (1974) default risk (MDR) model. The RSDR model supports an expanded range of asset probability density functions. First, we show using simulation that the RSDR model incorporates sudden changes in asset values faster than the MDR model. Second, we empirically implement the RSDR, MDR and an extension of the MDR model with changes in drift parameters, using maximum likelihood estimation. Focusing on the period before and after corporate rating downgrades used primarily for investment advice, we find that the RSDR model uses changes in equity mean returns and volatility to produce higher estimated default probabilities, faster, than both benchmark models.

Keywords: Default Risk, Regime Switching, Bond Ratings, MLE

JEL Classification: G12, G33

Suggested Citation

Milidonis, Andreas and Chisholm, Kevin, The Regime-Switching Structural Default Risk Model (January 12, 2024). Available at SSRN: https://ssrn.com/abstract=1929692 or http://dx.doi.org/10.2139/ssrn.1929692

Andreas Milidonis (Contact Author)

University of Cyprus - Department of Accounting and Finance ( email )

P.O. Box 20537
Nicosia CY-1678
Cyprus
+357 22 893 626 (Phone)

HOME PAGE: http://www.ucy.ac.cy/~amilidon/

Kevin Chisholm

Independent ( email )

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
231
Abstract Views
1,319
Rank
271,749
PlumX Metrics