Modeling Multi-Period Corporate Default Probability When Hazard Ratios Decay
Journal of Credit Risk, Forthcoming
15 Pages Posted: 27 Aug 2007 Last revised: 27 Apr 2012
Date Written: August 14, 2007
Abstract
A number of researchers have used the Cox Proportional Hazard Model to estimate multi-period corporate default probabilities. By construction, models estimated in this manner have hazard ratios that are constant over time. We present evidence, drawn from historical data, indicating that empirical hazard ratios, in fact, exhibit pronounced decay over time, contrary to the assumptions of the Cox Proportional Hazard Model. We provide a possible explanation for this phenomenon, in terms of the evolution, posited by other authors, of the explanatory variables. We propose a hazard rate model with time varying coefficients, which incorporates the decaying hazard ratio property. Our model outperforms the standard Cox regression on an out-of-sample/time experiment.
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