Regime-Switching And Levy Jump Dynamics In Option-Adjusted Spreads
21 Pages Posted: 12 Jan 2019 Last revised: 10 Jun 2019
Date Written: June 8, 2019
A regime-switching Levy framework, where all parameter values depend on the value of a continuous time Markov chain as per Chevallier and Goutte (2017), is employed to study US Corporate Option-Adjusted Spreads (OASs). For modelling purposes we assume a Normal Inverse Gaussian distribution, allowing heavier tails and skewness. After the Expectation-Maximization algorithm is applied to this general class of regime switching models, we compare the obtained results with time series models without jumps, including one with regime switching and one without. We find that a regime-switching Levy model clearly defines two regimes for A-, AA-, and AAA-rated OASs. We find further evidence of regime-switching effects, with data showing relatively pronounced jump intensity around the time of major crisis periods, thereby confirming the presence and importance of volatility regimes. Results indicate that ignoring the complex and dynamic dependence structure in favour of certain model assumptions may lead to a significant underestimation of risk.
Keywords: regime-switching, Levy, OAS, NIG
JEL Classification: G1, G12, G19, E5, C1, C13
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