A Hidden Markov Chain Model for the Term Structure of Bond Credit Risk Spreads
36 Pages Posted: 10 Aug 1998
Date Written: May 1998
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.
JEL Classification: G12, G13
Suggested Citation: Suggested Citation