Business Cycle and Credit Risk Modeling with Jump Risks
Posted: 25 Feb 2013 Last revised: 13 Aug 2016
Date Written: February 25, 2013
We develop a structural model that incorporates both macroeconomic risks and firm-specific jump risks. Using this model, we derive analytic formulas for default probability, equity price, and CDS spreads. We show that including the two types of risk in credit risk modeling can generate better explanations for firm's credit risks in the real world. Based on reasonably calibrated parameters, we find that our model could better predict actual default probabilities and overcome the underestimation of credit risks, especially for firms with high credit ratings, which has been one of the major limitations of the currently available structural models. The structural model proposed in this paper highlights that macroeconomic factors are important in modeling credit risks and that default probabilities, and CDS spreads could be dependent on the current economic state.
Keywords: credit risk, business cycle, jump risk, credit model, structural model, credit default swap
JEL Classification: C51, C63, E32, G33
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