Firm-Specific Credit Risk Estimation in the Presence of Regimes and Noisy Prices
17 Pages Posted: 3 May 2016 Last revised: 28 May 2017
Date Written: June 15, 2016
Security prices are important inputs for estimating credit risk. Yet, to obtain an accurate firm-specific credit risk assessment, one needs a reliable model and a methodology that filters the elements unrelated to the firm’s fundamentals from market prices.
In this article, we introduce a hybrid credit risk model defined in a Markov-switching environment. It captures firm-specific changes in the leverage uncertainty during crises. We also propose a new efficient method to estimate the model, and a numerical scheme based on trinomial lattices to price credit derivatives. The estimation is finally performed on more than 200 firms using maximum likelihood estimation.
Keywords: Credit risk, maximum likelihood estimation, regime-switching, filtering, noisy prices
JEL Classification: C51, C58, G01
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