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Comparing the reliability of a discrete-time and a continuous-time Markov chain model in determining credit risk

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  • Su-Lien Lu

Abstract

This article compares the reliability of a discrete-time and a continuous-time Markov chain model for estimating credit risk and for investigating loans of Chiao Tung Bank in Taiwan. The continuous-time Markov chain model can capture the migration of rare events. The time-varying risk premium was also extracted from the loan value and corresponding risk-free price and the transition matrix was transferred to risk-neutral transition matrix by the time-varying risk premium. Finally, the empirical results indicate that the discrete-time Markov chain model may be underestimating the default probability in both the lowest risk and speculative rating class. Comparing the loss given default and the NPL ratio, the continuous-time Markov chain model is more reliable and effective for gauging the credit risk of bank loans.

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  • Su-Lien Lu, 2009. "Comparing the reliability of a discrete-time and a continuous-time Markov chain model in determining credit risk," Applied Economics Letters, Taylor & Francis Journals, vol. 16(11), pages 1143-1148.
    • Handle: RePEc:taf:apeclt:v:16:y:2009:i:11:p:1143-1148
    DOI: 10.1080/13504850701349153
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