Bayesian analysis of structural credit risk models with microstructure noises

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jedc.2010.05.008 Byline: Shirley J. Huang (a), Jun Yu (b) Abstract: In this paper a Markov chain Monte Carlo (MCMC) technique is developed for the Bayesian analysis of structural credit risk models with microstructure noises. The technique is based on the general Bayesian approach with posterior computations performed by Gibbs sampling. Simulations from the Markov chain, whose stationary distribution converges to the posterior distribution, enable exact finite sample inferences of model parameters. The exact inferences can easily be extended to latent state variables and any nonlinear transformation of state variables and parameters, facilitating practical credit risk applications. In addition, the comparison of alternative models can be based on deviance information criterion (DIC) which is straightforwardly obtained from the MCMC output. The method is implemented on the basic structural credit risk model with pure microstructure noises and some more general specifications using daily equity data from US and emerging markets. We find empirical evidence that microstructure noises are positively correlated with the firm values in emerging markets. Author Affiliation: (a) Lee Kong Chian School of Business, Singapore Management University, 50 Stamford Road, Singapore 178899, Singapore (b) School of Economics and Sim Kee Boon Institute for Financial Economics, Singapore Management University, 90 Stamford Road, Singapore 178903, Singapore