A Regime Switching Model for the Term Structure of Credit Risk Spreads

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We consider a rating-based model for the term structure of credit risk spreads wherein the credit worthiness of the issuer is represented as a finite-state continuous time Markov process. This approach entails a progressive drift in creditquality towards default. A model of the economy is presented featuring stochastic transition probabilities; credit instruments are valued via an ultraparabolic Hamilton-Jacobi system of equations discretized utilizing the method-of-lines finite difference method. Computations for a callable bond are presented demonstrating the efficiency of the method.


Applied Mathematics | Finance and Financial Management