The aims of this paper are threefold. First, we highlight the usefulness of generalized linear mixed models (GLMMs) in the modelling of portfolio credit default risk. The GLMM-setting allows for a flexible specification of the systematic portfolio risk in terms of observed fixed effects and unobserved random effects, in order to explain the phenomena of default dependence and time-inhomogeneity in historical default data. Second, we show that computational Bayesian techniques such as the Gibbs sampler can be successfully applied to fit models with serially correlated random effects, which are special instances of state space models. Third, we provide an empirical study using Standard and Poor's data on U.S. firms. A model incorporating rating category and sector effects, and a macroeconomic proxy variable for state-of-the-economy suggests the presence of a residual, cyclical, latent component in the systematic risk.
- Bayesian inference
- Credit risk
- Generalized linear mixed model
- State space model