A Hidden Markov Chain Model for the Term Structure of Bond Credit Risk Spreads

by Lyn C. Thomas of the University of Edinburgh,
David E. Allen of Edith Cowan University, and
Nigel Morkel-Kingsbury of Edith Cowan University

March 1999

Abstract: This paper provides a Markov chain model for the term structure and credit risk spreads of bond process. It allows dependency between the stochastic process modeling the interest rate and the Markov chain process describing changes in the credit rating of the bonds by their mutual dependency on a hidden Markov chain. This Markov chain can be thought of as the underlying economic conditions. The model also allows a new interpretation of risk premia used in previous approaches. It also uses a linear programming approach to strip the bonds of their coupons in such a way as to guarantee there is no mis-pricing.

Published in: International Review of Financial Analysis, Vol. 11, No. 3, (2002), pp. 311-329.

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