TITLE:
A Regime Switching Model for the Term Structure of Credit Risk Spreads
AUTHORS:
Seungmook Choi, Michael D. Marcozzi
KEYWORDS:
Optimal Stopping, Failure Rate, Regime Switching, Credit Risk Spreads
JOURNAL NAME:
Journal of Mathematical Finance,
Vol.5 No.1,
February
13,
2015
ABSTRACT: We consider a rating-based model for the term structure of credit risk spreads wherein the credit-worthiness of the issuer is represented as a finite-state continuous time Markov process. This approach entails a progressive drift in credit quality towards default. A model of the economy is presented featuring stochastic transition probabilities; credit instruments are valued via an ultra parabolic Hamilton-Jacobi system of equations discretized utilizing the method-of-lines finite difference method. Computations for a callable bond are presented demonstrating the efficiency of the method.