Bayesian Estimation of Time-Changed Default Intensity Models

FEDS Working Paper No. 2015-002

http://dx.doi.org/10.17016/FEDS.2015.002

47 Pages Posted: 14 Feb 2015  

Michael B. Gordy

Board of Governors of the Federal Reserve

Pawel Szerszen

Board of Governors of the Federal Reserve System

Date Written: January 6, 2015

Abstract

We estimate a reduced-form model of credit risk that incorporates stochastic volatility in default intensity via stochastic time-change. Our Bayesian MCMC estimation method overcomes nonlinearity in the measurement equation and state-dependent volatility in the state equation. We implement on firm-level time-series of CDS spreads, and find strong in-sample evidence of stochastic volatility in this market. Relative to the widely-used CIR model for the default intensity, we find that stochastic time-change offers modest benefit in fitting the cross-section of CDS spreads at each point in time, but very large improvements in fitting the time-series, i.e., in bringing agreement between the moments of the default intensity and the model-implied moments. Finally, we obtain model-implied out-of-sample density forecasts via auxiliary particle filter, and find that the time-changed model strongly outperforms the baseline CIR model.

Keywords: Bayesian estimation, CDS, CIR process, Credit derivatives, MCMC, Particle filter, Stochastic time change

JEL Classification: G12, G17, C11, C15, C58

Suggested Citation

Gordy, Michael B. and Szerszen, Pawel, Bayesian Estimation of Time-Changed Default Intensity Models (January 6, 2015). FEDS Working Paper No. 2015-002. Available at SSRN: https://ssrn.com/abstract=2561525 or http://dx.doi.org/10.2139/ssrn.2561525

Michael B. Gordy

Board of Governors of the Federal Reserve ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3705 (Phone)

Pawel Szerszen (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://www.federalreserve.gov/research/staff/szerszenpawelj.htm

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