An Empirical Investigation of CDS Spreads Using a Regime Switching Default Risk Model

North American Actuarial Journal, Forthcoming

41 Pages Posted: 13 Jun 2015 Last revised: 5 Nov 2015

See all articles by Andreas Milidonis

Andreas Milidonis

University of Cyprus - Department of Accounting and Finance

Date Written: June 13, 2015

Abstract

Default risk in equity returns can be measured by structural models of default. In this paper we propose a credit warning signal (CWS) based on the Merton default risk (MDR) model and a Regime-switching default risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using the dataset of US credit default swap (CDS) contracts we construct rating based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in default probabilities several months ahead of notable increases in CDS spreads.

Keywords: Default Risk, Regime Switching, Credit Warning Signal, CDS.

JEL Classification: G13, G17.

Suggested Citation

Milidonis, Andreas, An Empirical Investigation of CDS Spreads Using a Regime Switching Default Risk Model (June 13, 2015). North American Actuarial Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2616121 or http://dx.doi.org/10.2139/ssrn.2616121

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/

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

Paper statistics

Downloads
95
Abstract Views
667
rank
344,538
PlumX Metrics