Abstract
This paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of Credit Default Swap rates for the major US banking groups over the period of the financial crisis. Affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate. In contrast, first passage time models are specified in terms of the distance to default rather than the hazard rate. The persistence of shocks varies with the distance to default, allowing the default curve to invert sharply (compress) when the distance to default is low (high). I use an empirical version of the Collin-Dufresne et al. (2003) model, which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag.
Original language | English |
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Pages (from-to) | 168-182 |
Number of pages | 15 |
Journal | Journal of Banking & Finance |
Volume | 71 |
Early online date | 25 Jun 2016 |
DOIs | |
Publication status | Published - Oct 2016 |
Bibliographical note
Publisher Copyright:© 2016 Elsevier B.V.
Keywords
- Asset pricing
- Bank solvency
- Banking efficiency
- Banking regulation