Intensity of default in sovereign bonds: Estimation of an unobservable process

Otero, Karina V. (2016): Intensity of default in sovereign bonds: Estimation of an unobservable process.

Abstract

This paper proposes a new approach to estimate general stationary diffusion processes that describe the evolution of unobserved arrival rates of credit events on sovereign bonds, allowing for arbitrary parametric drift and diffusion specifications. The solutions and transition processes for stationary diffusions are generally unknown in closed form and therefore standard maximum likelihood methods do not apply. Moreover, the arrival rates of credit events on sovereign bonds are unobservable and a direct nonparametric estimation does not work. This paper overcomes these challenges combining a semi-nonparametric estimator in the framework of the Efficient Method of Moments, Gallant and Tauchen (1996), and a reduced-form model for pricing sovereign bonds and credit default swaps. The application for Brazil sovereign assets explores the performance of the model under different specifications of the intensity process.

• Item Type: MPRA Paper
• Language: English
• Keywords: Efficient Method of Moments (EMM), semi-nonparametric (SNP) econometrics, Hermite, latent variables, estimation of stochastic differential equations, estimation of diffusions, asset pricing, numerical methods for partial differential equations, credit risk, cox process, credit derivatives, credit default swaps (CDS).
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C14 - Semiparametric and Nonparametric Methods: General; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

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