Quality Control for Structural Credit Risk Models

Elena Andreou and Eric Ghysels

University of Cyprus Working Papers in Economics from University of Cyprus Department of Economics

Abstract: Over the last four decades, a large number of structural models have been developed to estimate and price credit risk. The focus of the paper is on a neglected issue pertaining to fundamental shifts in the structural parameters governing default. We propose formal quality control procedures that allow risk managers to monitor fundamental shifts in the structural parameters of credit risk models. The procedures are sequential - hence apply in real time. The basic ingredients are the key processes used in credit risk analysis, such as most prominently the Merton distance to default process as well as financial returns. Moreover, while we propose different monitoring processes, we also show that one particular process is optimal in terms of minimal detection time of a break in the drift process and relates to the Radon-Nikodym derivative for a change of measure.

Pages: 28 pages
Date: 2007-02
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Journal Article: Quality control for structural credit risk models (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:ucy:cypeua:3-2007

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