Working Paper Series no. 340: Default, liquidity and crises: an econometric framework

Abstract

In this paper, we present a general discrete-time affine framework aimed at jointly modeling yield curves associated with different debtors. The underlying fixed-income securities may differ in terms of credit quality and/or in terms of liquidity. The risk factors follow conditionally Gaussian processes, with drifts and variance-covariance matrices that are subject to regime shifts described by a Markov chain with (historical) non-homogenous transition probabilities. While flexible, the model remains tractable. In particular, bond prices are given by quasi-explicit formulas. Various numerical examples are proposed, including a sector-contagion model and credit-rating modeling.

Alain Monfort and Jean-Paul Renne
August 2011

Classification JEL : E43, E44, E47, G12, G24

Keywords : credit risk, liquidity risk, term structure, affine model, regime switching, Car process