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Does the GARCH Structural Credit Risk Model Make a Difference?

Author

Listed:
  • Thorsten Lehnert
  • Xisong Jin
  • Francisco Nadal de Simone

    (LSF)

Abstract

In this study, we empirically investigate and evaluate various approaches to structurally assess credit risk using a panel of European banking groups. We consider not only the standard approaches in the literature, but also include models that allow the asset volatility to be stochastic and models that allow for short- and long-term components of default risk. Models are evaluated by comparing their ability to correctly and timely identify changes in risk indicators. Surprisingly, we find that the GARCH structural credit risk model, despite its more sophisticated modeling approach, typically underperforms more basic models. Importantly for macro-prudential policy, the combined Merton/GARCH-MIDAS model performs best and reflects important market events earlier than the other approaches.

Suggested Citation

  • Thorsten Lehnert & Xisong Jin & Francisco Nadal de Simone, 2011. "Does the GARCH Structural Credit Risk Model Make a Difference?," LSF Research Working Paper Series 11-6, Luxembourg School of Finance, University of Luxembourg.
    • Handle: RePEc:crf:wpaper:11-6
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    File URL: http://wwwen.uni.lu/content/download/56106/665288/file/Does%20the%20GARCH%20Structural%20Credit%20Risk%20Model%20Make%20Difference%20(6).pdf
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    Cited by:

    1. Xisong Jin & Francisco Nadal de Simone, 2011. "Market- and Book-Based Models of Probability of Default for Developing Macroprudential Policy Tools," BCL working papers 65, Central Bank of Luxembourg.
    2. Jin, Xisong & Nadal De Simone, Francisco de A., 2014. "Banking systemic vulnerabilities: A tail-risk dynamic CIMDO approach," Journal of Financial Stability, Elsevier, vol. 14(C), pages 81-101.
    3. Xisong Jin & Francisco Nadal De Simone, 2012. "An Early-warning and Dynamic Forecasting Framework of Default Probabilities for the Macroprudential Policy Indicators Arsenal," BCL working papers 75, Central Bank of Luxembourg.

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