Discrete versus Continuous State Switching Models for Portfolio Credit Risk

Andre Lucas and Pieter Klaassen ()
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Pieter Klaassen: ABN AMRO Bank NV, Amsterdam

No 03-075/2, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: Dynamic models for credit rating transitions are important ingredients for dynamic credit risk analyses. We compare the properties of two such models that have recently been put forward. The models mainly differ in their treatment of systematic risk, which can be modeled either using discrete states (e.g., expansion versus recession) or continous states. It turns out that the implied asset correlations for discrete state switching models are implausibly low compared to correlation estimates in the literature. Given these limited correlations, we conclude that care has to be taken when discrete state regime switching models are employed for dynamic credit risk management. As a side result of our analysis, we obtain indirect evidence that default correlations may change over the business cycle.

Keywords: credit risk; regime switching; latent variable models; factor models (search for similar items in EconPapers)
JEL-codes: C22 C53 G21 (search for similar items in EconPapers)
Date: 2003-09-29, Revised 2003-09-30
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Discrete versus continuous state switching models for portfolio credit risk (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:tin:wpaper:20030075

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