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Bayesian Estimation of Time-Changed Default Intensity Models

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Abstract
We estimate a reduced-form model of credit risk that incorporates stochastic volatility in default intensity via stochastic time-change. Our Bayesian MCMC estimation method overcomes nonlinearity in the measurement equation and state-dependent volatility in the state equation. We implement on firm-level time-series of CDS spreads, and find strong in-sample evidence of stochastic volatility in this market. Relative to the widely-used CIR model for the default intensity, we find that stochastic time-change offers modest benefit in fitting the cross-section of CDS spreads at each point in time, but very large improvements in fitting the time-series, i.e., in bringing agreement between the moments of the default intensity and the model-implied moments. Finally, we obtain model-implied out-of-sample density forecasts via auxiliary particle filter, and find that the time-changed model strongly outperforms the baseline CIR model.

Suggested Citation

  • Michael B. Gordy & Pawel J. Szerszen, 2015. "Bayesian Estimation of Time-Changed Default Intensity Models," Finance and Economics Discussion Series 2015-2, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2015-02
    DOI: 10.17016/FEDS.2015.002
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    References listed on IDEAS

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    Cited by:

    1. Lin, Feng & Peng, Liang & Xie, Jiehua & Yang, Jingping, 2018. "Stochastic distortion and its transformed copula," Insurance: Mathematics and Economics, Elsevier, vol. 79(C), pages 148-166.

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    More about this item

    Keywords

    Bayesian estimation; CDS; CIR process; credit derivatives; MCMC; particle filter; stochastic time change;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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