An Empirical Investigation of CDS Spreads Using a Regime-Switching Default Risk Model. Issue 3 (2nd July 2016)

• Record Type: Journal Article
• Authors: Milidonis, Andreas
• Is Part Of: North American actuarial journal. Volume 20:Issue 3(2016)
• Page Start: 252
• Page End: 275
• Publication Date: 2016-07-02
• Subjects: Life insurance -- Research -- North America -- Periodicals; Actuarial science -- North America -- Periodicals; Web sites; Electronic journals; 368.010973
• DOI: 10.1080/10920277.2016.1180996
• Languages: English
• ISSNs: 2325-0453

Abstract

Abstract : Default risk in equity returns can be measured by structural models of default. In this article we propose a credit warning signal (CWS) based on the Merton Default Risk (MDR) model and a Regime-Switching Default Risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics, and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using a dataset of U.S. credit default swap (CDS) contracts around the 2007-8 crisis we construct rating-based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in implied default probabilities several months ahead of notable increases in CDS spreads.