A Hidden Markov Chain Model for the Term Structure of Bond Credit Risk Spreads

Posted: 20 Aug 2001

See all articles by Lyn C. Thomas

Lyn C. Thomas

University of Southampton - School of Management

David E. Allen

School of Mathematics and Statistics, The University of Sydney; Financial Research Network (FIRN); Department of Finance; School of Business and Law, Edith Cowan University

Nigel Morkel-Kingsbury

RMIT University; Federation University Australia

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Abstract

This paper provides a Markov chain model for the term structure and credit risk spreads of bond prices. It allows dependency between the stochastic process modeling the interest rate and the Markov chain process describing changes in the credit rating of the bonds by their mutual dependency on a hidden Markov chain, which can be thought of as describing the underlying economic conditions. The model also allows a new interpretation of risk premia used in previous approaches and also uses a linear programming approach to strip the bonds of their coupons in such a way as to guarantee there is no mis-pricing.

Keywords: Bond pricing, credit ratings, credit spread, linear programming, Markov Chain, risk premium

JEL Classification: G12

Suggested Citation

Thomas, Lyn C. and Allen, David Edmund and Morkel-Kingsbury, Nigel, A Hidden Markov Chain Model for the Term Structure of Bond Credit Risk Spreads. International Review of Financial Analysis. Available at SSRN: https://ssrn.com/abstract=278656

Lyn C. Thomas

University of Southampton - School of Management ( email )

Highfield
Southampton S017 1BJ, Hampshire SO17 1BJ
United Kingdom
(023) 8059 7718 (Phone)
(023) 8059 3844 (Fax)

David Edmund Allen (Contact Author)

School of Mathematics and Statistics, The University of Sydney ( email )

School of Mathematics and Statistics F07
University of Sydney
Sydney, New South Wales 2006
Australia

HOME PAGE: http://www.maths.usyd.edu.au

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Department of Finance ( email )

Taiwan
Taiwan

School of Business and Law, Edith Cowan University

100 Joondalup Drive
Joondalup, WA 6027
Australia

HOME PAGE: http://www.dallenwapty.com

Nigel Morkel-Kingsbury

RMIT University ( email )

124 La Trobe Street
Melbourne, 3000
Australia

Federation University Australia ( email )

University Dr.
Mt Helen, Victoria 3350
Australia

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