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An Empirical Investigation of CDS Spreads Using a Regime-Switching Default Risk Model

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  • Andreas Milidonis

Abstract

Default risk in equity returns can be measured by structural models of default. In this article we propose a credit warning signal (CWS) based on the Merton Default Risk (MDR) model and a Regime-Switching Default Risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics, and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using a dataset of U.S. credit default swap (CDS) contracts around the 2007-8 crisis we construct rating-based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in implied default probabilities several months ahead of notable increases in CDS spreads.

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  • Andreas Milidonis, 2016. "An Empirical Investigation of CDS Spreads Using a Regime-Switching Default Risk Model," North American Actuarial Journal, Taylor & Francis Journals, vol. 20(3), pages 252-275, July.
    • Handle: RePEc:taf:uaajxx:v:20:y:2016:i:3:p:252-275
    DOI: 10.1080/10920277.2016.1180996
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