Quantile Forecasting for Credit Risk Management using possibly Mis-specified Hidden Markov Models
AbstractRecent models for credit risk management make use of Hidden Markov Models (HMMs). The HMMs are used to forecast quantiles of corporate default rates. Little research has been done on the quality of such forecasts if the underlying HMM is potentially mis-specified. In this paper, we focus on mis-specification in the dynamics and the dimension of the HMM. We consider both discrete and continuous state HMMs. The differences are substantial. Underestimating the number of discrete states has an economically significant impact on forecast quality. Generally speaking, discrete models underestimate the high-quantile default rate forecasts. Continuous state HMMs, however, vastly overestimate high quantiles if the true HMM has a discrete state space. In the reverse setting, the biases are much smaller, though still substantial in economic terms. We illustrate the empirical differences using U.S. default data.
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Bibliographic InfoPaper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 07-046/2.
Date of creation: 13 Jun 2007
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defaults; Markov switching; misspecification; quantile forecast; Expectation-Maximization; simulated maximum likelihood; importance sampling;
Other versions of this item:
- Konrad Banachewicz & André Lucas, 2008. "Quantile forecasting for credit risk management using possibly misspecified hidden Markov models," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 27(7), pages 566-586.
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-07-07 (All new papers)
- NEP-ECM-2007-07-07 (Econometrics)
- NEP-FOR-2007-07-07 (Forecasting)
- NEP-RMG-2007-07-07 (Risk Management)
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