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Recovering default risk from CDS spreads with a nonlinear filter |
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| Institution: | 1. Leibniz University Hannover, Koenigsworther Platz 1, D-30167 Hannover, Germany;2. ICMA Centre, Henley Business School, University of Reading, RG6 6BA, UK;3. Norwich Business School, University of East Anglia, Norwich NR4 7TJ, United Kingdom;1. Carroll School of Management, Boston College140 Commonwealth Avenue, Chestnut Hill, MA 02467, USA;2. McCombs School of Business, The University of Texas at Austin, 1 University Station, B6600, Austin, TX 78712, USA |
| Abstract: | We propose a nonlinear filter to estimate the time-varying default risk from the term structure of credit default swap (CDS) spreads. Based on the numerical solution of the Fokker–Planck equation (FPE) using a meshfree interpolation method, the filter performs a joint estimation of the risk-neutral default intensity and CIR model parameters. As the FPE can account for nonlinear functions and non-Gaussian errors, the proposed framework provides outstanding flexibility and accuracy. We test the nonlinear filter on simulated spreads and apply it to daily CDS data of the Dow Jones Industrial Average component companies from 2005 to 2010 with supportive results. |
| Keywords: | CDS spreads Meshfree methods Radial basis function interpolation Fokker–Planck equation CIR model |
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