Default Likelihood Under Regime-Switching

Abstract

We develop the regime-switching default risk (RSDR) model as a generalization of Merton’s (1974) 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. 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.