Modeling Portfolio Defaults using Hidden Markov Models with Covariates

Konrad Banachewicz (), Aad van der Vaart () and Andre Lucas
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Konrad Banachewicz: Vrije Universiteit Amsterdam
Aad van der Vaart: Vrije Universiteit Amsterdam

No 06-094/2, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: We extend the Hidden Markov Model for defaults of Crowder, Davis, and Giampieri (2005) to include covariates. The covariates enhance the prediction of transition probabilities from high to low default regimes. To estimate the model, we extend the EM estimating equations to account for the time varying nature of the conditional likelihoods due to sample attrition and extension. Using empirical U.S. default data, we find that GDP growth, the term structure of interest rates and stock market returns impact the state transition probabilities. The impact, however, is not uniform across industries. We only find a weak correspondence between industry credit cycle dynamics and general business cycles.

Keywords: defaults; Markov switching; default regimes (search for similar items in EconPapers)
JEL-codes: C22 G21 G33 (search for similar items in EconPapers)
Date: 2006-10-25
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Journal Article: Modelling Portfolio Defaults Using Hidden Markov Models with Covariates (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:tin:wpaper:20060094

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