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The Regime-Switching Structural Default Risk Model

Author

Listed:
  • Andreas Milidonis

    (Department of Accounting & Finance, Faculty of Economics & Management, University of Cyprus, P.O. Box 420537, CY-1678 Nicosia, Cyprus)

  • Kevin Chisholm

    (Accounting and Finance Division, Alliance MBS, University of Manchester, Manchester M13 9PL, UK)

Abstract

We develop the regime-switching default risk ( RSDR ) model as a generalization of Merton’s default risk ( MDR ) model. The RSDR model supports an expanded range of asset probability density functions. First, we show using simulation that the RSDR model incorporates sudden changes in asset values faster than the MDR model. Second, we empirically implement the RSDR , MDR and an extension of the MDR model with changes in drift parameters, using maximum likelihood estimation. Focusing on the period before and after corporate rating downgrades used primarily for investment advice, we find that the RSDR model uses changes in equity mean returns and volatility to produce higher estimated default probabilities, faster, than both benchmark models.

Suggested Citation

  • Andreas Milidonis & Kevin Chisholm, 2024. "The Regime-Switching Structural Default Risk Model," Risks, MDPI, vol. 12(3), pages 1-33, March.
    • Handle: RePEc:gam:jrisks:v:12:y:2024:i:3:p:48-:d:1351001
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    References listed on IDEAS

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