IDEAS home Printed from https://ideas.repec.org/a/kap/compec/v26y2005i3p69-102.html
   My bibliography  Save this article

Extracting Information from Spot Interest Rates and Credit Ratings using Double Higher-Order Hidden Markov Models

Author

Listed:
  • Tak-Kuen Siu
  • Wai-Ki Ching
  • Eric Fung
  • Michael Ng

Abstract

Estimating and forecasting the unobservable states of an economy are important and practically relevant topics in economics. Central bankers and regulators can use information about the market expectations on the hidden states of the economy as a reference for decision and policy makings, for instance, deciding monetary policies. Spot interest rates and credit ratings of bonds contain important information about the hidden sequence of the states of the economy. In this paper, we develop double higher-order hidden Markov chain models (DHHMMs) for extracting information about the hidden sequence of the states of an economy from the spot interest rates and credit ratings of bonds. We consider a discrete-state model described by DHHMMs and focus on the qualitative aspect of the unobservable states of the economy. The observable spot interest rates and credit ratings of bonds depend on the hidden states of the economy which are modelled by DHHMMs. The DHHMMs can incorporate the persistent phenomena of the time series of spot interest rates and the credit ratings. We employ the maximum likelihood method and the EM algorithm, namely Viterbi's algorithm, to uncover the optimal hidden sequence of the states of the economy which can be interpreted the “best” estimate of the sequence of the underlying economic states generating the spot interest rates and credit ratings of the bonds. Then, we develop an efficient maximum likelihood estimation method to estimate the unknown parameters in our model. Numerical experiment will be conducted to illustrate the implementation of the model. Copyright Springer Science+Business Media, Inc. 2005

Suggested Citation

  • Tak-Kuen Siu & Wai-Ki Ching & Eric Fung & Michael Ng, 2005. "Extracting Information from Spot Interest Rates and Credit Ratings using Double Higher-Order Hidden Markov Models," Computational Economics, Springer;Society for Computational Economics, vol. 26(3), pages 69-102, November.
    • Handle: RePEc:kap:compec:v:26:y:2005:i:3:p:69-102
    DOI: 10.1007/s10614-005-9010-6
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1007/s10614-005-9010-6
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1007/s10614-005-9010-6?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Stefan Gerlach & Matthew S. Yiu, 2004. "A Dynamic Factor Model for Current-Quarter Estimates of Economic Activity in Hong Kong," Working Papers 162004, Hong Kong Institute for Monetary Research.
    2. Gonzalo Camba-Mendez & George Kapetanios & Richard J. Smith & Martin R. Weale, 2001. "An automatic leading indicator of economic activity: forecasting GDP growth for European countries," Econometrics Journal, Royal Economic Society, vol. 4(1), pages 1-37.
    3. Sargent, Thomas J, 1973. "Interest Rates and Prices in the Long Run: A Study of the Gibson Paradox," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 5(1), pages 385-449, Part II F.
    4. Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000. "Stability of rating transitions," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 203-227, January.
    5. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    6. Jiang Wang, 1993. "A Model of Intertemporal Asset Prices Under Asymmetric Information," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(2), pages 249-282.
    7. Ang, Andrew & Bekaert, Geert, 2002. "Regime Switches in Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 163-182, April.
    8. Stock, James H. & Watson, Mark W., 1999. "Business cycle fluctuations in us macroeconomic time series," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 1, pages 3-64, Elsevier.
    9. Gerlach, Stefan, 2003. "Interpreting the term structure of interbank rates in Hong Kong," Pacific-Basin Finance Journal, Elsevier, vol. 11(5), pages 593-609, November.
    10. James H. Stock & Mark W. Watson, 1989. "New Indexes of Coincident and Leading Economic Indicators," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 351-409, National Bureau of Economic Research, Inc.
    11. Thomas, Lyn C. & Allen, David E. & Morkel-Kingsbury, Nigel, 2002. "A hidden Markov chain model for the term structure of bond credit risk spreads," International Review of Financial Analysis, Elsevier, vol. 11(3), pages 311-329.
    12. Mr. Christian B. Mulder & Brieuc Monfort, 2000. "Using Credit Ratings for Capital Requirementson Lending to Emerging Market Economies: Possible Impact of a New Basel Accord," IMF Working Papers 2000/069, International Monetary Fund.
    13. Arthur F. Burns & Wesley C. Mitchell, 1946. "Measuring Business Cycles," NBER Books, National Bureau of Economic Research, Inc, number burn46-1.
    14. Margaret R. Maier & Nigel Meade, 2003. "Evidence of long memory in short-term interest rates," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 22(8), pages 553-568.
    15. Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
    16. Duan, Jin-Chuan & Jacobs, Kris, 1996. "A simple long-memory equilibrium interest rate model," Economics Letters, Elsevier, vol. 53(3), pages 317-321, December.
    17. Shin-ichi Fukuda & Takashi Onodera, 2001. "A New Composite Index of Coincident Economic Indicators in Japan: How can we improve the forecast performance? ," CIRJE F-Series CIRJE-F-101, CIRJE, Faculty of Economics, University of Tokyo.
    18. Detemple, Jerome B, 1986. "Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-391, June.
    19. Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Zhu, Dong-Mei & Lu, Jiejun & Ching, Wai-Ki & Siu, Tak-Kuen, 2017. "Discrete-time optimal asset allocation under Higher-Order Hidden Markov Model," Economic Modelling, Elsevier, vol. 66(C), pages 223-232.
    2. Xi, Xiaojing & Mamon, Rogemar, 2011. "Parameter estimation of an asset price model driven by a weak hidden Markov chain," Economic Modelling, Elsevier, vol. 28(1-2), pages 36-46, January.
    3. Xi, Xiaojing & Mamon, Rogemar, 2011. "Parameter estimation of an asset price model driven by a weak hidden Markov chain," Economic Modelling, Elsevier, vol. 28(1), pages 36-46.
    4. Xiaojing Xi & Rogemar Mamon, 2014. "Capturing the Regime-Switching and Memory Properties of Interest Rates," Computational Economics, Springer;Society for Computational Economics, vol. 44(3), pages 307-337, October.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. André Lucas & Siem Jan Koopman, 2005. "Business and default cycles for credit risk," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 20(2), pages 311-323.
    2. Hansson, Jesper & Jansson, Per & Löf, Mårten, 2003. "Business Survey Data: Do They Help in Forecasting the Macro Economy?," Working Papers 84, National Institute of Economic Research.
    3. Areski Cousin & Jérôme Lelong & Tom Picard, 2023. "Rating transitions forecasting: a filtering approach," Post-Print hal-03347521, HAL.
    4. Areski Cousin & J'er^ome Lelong & Tom Picard, 2021. "Rating transitions forecasting: a filtering approach," Papers 2109.10567, arXiv.org, revised Jun 2023.
    5. Linda Allen & Anthony Saunders, 2003. "A survey of cyclical effects in credit risk measurement model," BIS Working Papers 126, Bank for International Settlements.
    6. Areski Cousin & Jérôme Lelong & Tom Picard, 2022. "Rating transitions forecasting: a filtering approach," Working Papers hal-03347521, HAL.
    7. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403.
    8. Agnello, Luca & Schuknecht, Ludger, 2011. "Booms and busts in housing markets: Determinants and implications," Journal of Housing Economics, Elsevier, vol. 20(3), pages 171-190, September.
    9. Salvador, Carlos & Pastor, Jose Manuel & Fernández de Guevara, Juan, 2014. "Impact of the subprime crisis on bank ratings: The effect of the hardening of rating policies and worsening of solvency," Journal of Financial Stability, Elsevier, vol. 11(C), pages 13-31.
    10. Donatella Baiardi & Carluccio Bianchi, 2010. "Un Indicatore di Attività Economica per la Lombardia e per le Province di Milano e Pavia," Quaderni di Dipartimento 130, University of Pavia, Department of Economics and Quantitative Methods.
    11. Fuertes, Ana-Maria & Kalotychou, Elena, 2007. "On sovereign credit migration: A study of alternative estimators and rating dynamics," Computational Statistics & Data Analysis, Elsevier, vol. 51(7), pages 3448-3469, April.
    12. Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
    13. Guglielmo Caporale & Luis Gil-Alana, 2016. "Persistence and cyclical dependence in the monthly euribor rate," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 40(1), pages 157-171, January.
    14. Filippo Altissimo & Riccardo Cristadoro & Mario Forni & Marco Lippi & Giovanni Veronese, 2010. "New Eurocoin: Tracking Economic Growth in Real Time," The Review of Economics and Statistics, MIT Press, vol. 92(4), pages 1024-1034, November.
    15. Hanan Naser, 2015. "Estimating and forecasting Bahrain quarterly GDP growth using simple regression and factor-based methods," Empirical Economics, Springer, vol. 49(2), pages 449-479, September.
    16. Thomas M. FULLERTON & Macie Z. SUBIA, 2017. "Metropolitan Business Cycle Analysis for Lubbock," Journal of Economics and Political Economy, KSP Journals, vol. 4(1), pages 33-52, March.
    17. Narcisa Kadlcakova & Joerg Keplinger, 2004. "Credit Risk and Bank Lending in the Czech Republic," Working Papers 2004/06, Czech National Bank.
    18. Robert Inklaar & Jan Jacobs & Ward Romp, 2005. "Business Cycle Indexes: Does a Heap of Data Help?," Journal of Business Cycle Measurement and Analysis, OECD Publishing, Centre for International Research on Economic Tendency Surveys, vol. 2004(3), pages 309-336.
    19. Brian BARNARD, 2017. "Rating Migration and Bond Valuation: Decomposing Rating Migration Matrices from Market Data via Default Probability Term Structures," Expert Journal of Finance, Sprint Investify, vol. 5(1), pages 49-72.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:kap:compec:v:26:y:2005:i:3:p:69-102. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.springer.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.