A dynamic binomial expansion technique for credit risk measurement

a Bayesian filtering approach

Wing Hoe Woo, Tak Kuen Siu*

*Corresponding author for this work

Research output: Contribution to journalArticle

5 Citations (Scopus)

Abstract

Credit risk measurement and management are important and current issues in the modern finance world from both the theoretical and practical perspectives. There are two major schools of thought for credit risk analysis, namely the structural models based on the asset value model originally proposed by Merton and the intensity-based reduced form models. One of the popular credit risk models used in practice is the Binomial Expansion Technique (BET) introduced by Moody's. However, its one-period static nature and the independence assumption for credit entities' defaults are two shortcomings for the use of BET in practical situations. Davis and Lo provided elegant ways to ease the two shortcomings of BET with their default infection and dynamic continuous-time intensity-based approaches. This paper first proposes a discrete-time dynamic extension to the BET in order to incorporate the time-dependent and time-varying behaviour of default probabilities for measuring the risk of a credit risky portfolio. In reality, the 'true' default probabilities are unobservable to credit analysts and traders. Here, the uncertainties of 'true' default probabilities are incorporated in the context of a dynamic Bayesian paradigm. Numerical studies of the proposed model are provided.

Original languageEnglish
Pages (from-to)165-186
Number of pages22
JournalApplied Mathematical Finance
Volume11
Issue number2
DOIs
Publication statusPublished - Jun 2004
Externally publishedYes

Keywords

  • Bayesian filtering method
  • Binomial expansion technique (BET)
  • Credit risk measurement
  • Default probabilities
  • Value at risk (VaR)

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