Estimating the Probabilities of Default under the Assumption of Unobserved Heterogeneity

Jacob Oded and Itzhak Venezia

Chapter 98 in Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives:In 4 Volumes, 2024, pp 3255-3276 from World Scientific Publishing Co. Pte. Ltd.

Abstract: Bond default and rank transition are often modeled as a Markov chain with an absorbing state. However, recent studies have shown that the theory does not match the empirical data. We suggest that this mismatch possibly arises from unobserved heterogeneity and we examine via a numerical example whether increased heterogeneity reduces, as expected, the accuracy of the estimated defaults. The extent to which this reduction is economically significant is also considered. We then suggest a methodology for identifying the heterogeneity parameters and for testing their explanatory power.

Keywords: Financial Accounting; Financial Auditing; Mutual Funds; Hedge Funds; Asset Pricing; Options; Portfolio Analysis; Risk Management; Investment Analysis; Momentum Analysis; Behavior Analysis; Futures; Index Futures; CDCs; Financial Econometrics; Statistics; Financial Derivatives; Financial Accounting (search for similar items in EconPapers)
JEL-codes: G1 G11 G12 G3 M41 M42 (search for similar items in EconPapers)
Date: 2024
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