47 Pages Posted: 14 Feb 2015
Date Written: January 6, 2015
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: 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