A Generalized Endogenous Grid Method for Default Risk Models

41 Pages Posted: 24 Aug 2019 Last revised: 6 Mar 2021

See all articles by Youngsoo Jang

Youngsoo Jang

University of Queensland - School of Economics

Soyoung Lee

The Ohio State University - Department of Economics

Date Written: March 2021

Abstract

Default risk models have been widely employed to assess the ability of households and sovereigns to insure themselves against shocks. Grid search has often been used to solve these models because the complexity of the problem prevents the use of faster but less general methods. In this paper, we propose an extension of the endogenous grid method for default risk models, which is faster and more accurate than grid search. In particular, we find that our solution method leads to a more accurate bond price function, thus making substantial differences in the model’s main predictions. When applied to Arellano’s (2008) model, our approach predicts a standard deviation of the interest rate spread one-third lower and defaults 3 to 5 times less frequently than does the conventional approach. On top of that, our method is efficient. It is approximately 4 to 7 times faster than grid search when applied to a canonical model of Arellano (2008) and 19 to 27 times faster than grid search when applied to the richer model of Nakajima and Rıos-Rull (2014). Finally, we show that our method is applicable to a broad class of default risk models by characterizing sufficient conditions.

Keywords: Endogenous Grid Method, Default, Bankruptcy

JEL Classification: C63

Suggested Citation

Jang, Youngsoo and Lee, Soyoung, A Generalized Endogenous Grid Method for Default Risk Models (March 2021). Available at SSRN: https://ssrn.com/abstract=3442070 or http://dx.doi.org/10.2139/ssrn.3442070

Youngsoo Jang (Contact Author)

University of Queensland - School of Economics ( email )

St Lucia
Brisbane, Queensland 4072
Australia

Soyoung Lee

The Ohio State University - Department of Economics ( email )

United States

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