The Changing Shape of Sovereign Default Intensities

Abstract

The term structure of sovereign default intensities evolves over time along with rising/declining levels and steeping/flatting of the slope; a hump shape may exist in the default intensity curve, and the location of the hump changes. Thus, the default intensity model should have the flexibility to capture most of the variations in the term structure of the default intensities. The dynamic Nelson–Siegel (DNS) model with a time-varying decay parameter is appropriate to generate such default intensity curves. The paper studies the default intensities estimated from credit default swap (CDS) spreads by the DNS model with a time-varying decay parameter. Empirical studies were conducted on the German and U.S. CDS markets. The model parameters were successfully estimated using the Kalman filter. It is found that the decay parameters change over time and the magnitude of the decay parameter is positively related to the level of default intensities.