Extracting information from spot interest rates and credit ratings using double higher-order hidden Markov models

Tak Kuen Siu*, Wai Ki Ching, Eric S. Fung, Michael K. Ng

*Corresponding author for this work

Research output: Contribution to journalArticle

11 Citations (Scopus)

Abstract

Estimating and forecasting the unobservable states of an economy are important and practically relevant topics in economics. Central bankers and regulators can use information about the market expectations on the hidden states of the economy as a reference for decision and policy makings, for instance, deciding monetary policies. Spot interest rates and credit ratings of bonds contain important information about the hidden sequence of the states of the economy. In this paper, we develop double higher-order hidden Markov chain models (DHHMMs) for extracting information about the hidden sequence of the states of an economy from the spot interest rates and credit ratings of bonds. We consider a discrete-state model described by DHHMMs and focus on the qualitative aspect of the unobservable states of the economy. The observable spot interest rates and credit ratings of bonds depend on the hidden states of the economy which are modelled by DHHMMs. The DHHMMs can incorporate the persistent phenomena of the time series of spot interest rates and the credit ratings. We employ the maximum likelihood method and the EM algorithm, namely Viterbi's algorithm, to uncover the optimal hidden sequence of the states of the economy which can be interpreted the "best" estimate of the sequence of the underlying economic states generating the spot interest rates and credit ratings of the bonds. Then, we develop an efficient maximum likelihood estimation method to estimate the unknown parameters in our model. Numerical experiment will be conducted to illustrate the implementation of the model.

Original languageEnglish
Pages (from-to)251-284
Number of pages34
JournalComputational Economics
Volume26
Issue number3-4
DOIs
Publication statusPublished - Nov 2005
Externally publishedYes

Bibliographical note

An erratum of this article exists and can be found in Computational Economics, vol. 29, issue 3-4, p. 425. DOI: 10.1007/s10614-006-9057-z.

Keywords

  • credit ratings
  • double higher-order hidden markov model
  • long range dependence
  • optimal hidden economic states
  • spot interest rates

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