Firm-specific credit risk estimation in the presence of regimes and noisy prices

Abstract

Security prices are important inputs for estimating credit risk. Yet, to obtain an accurate firm-specific credit risk assessment, one needs a reliable model and a methodology that filters the elements unrelated to the firm’s fundamentals from market prices.In this article, we introduce a hybrid credit risk model defined in a Markov-switching environment. It captures firm-specific changes in the leverage uncertainty during crises. We also propose a new efficient method to estimate the model, and a numerical scheme based on trinomial lattices to price credit derivatives. The estimation is finally performed on more than 200 firms using maximum likelihood estimation.