Modelling Credit Spreads for Counterparty Risk: Mean-Reversion is not Needed
Published in Intelligent Risk, Oct’12
When modelling credit spreads, there is some controversy in the market as to whether they are mean-reverting or not. This is particularly important in the context of counterparty risk, at least for risk management and capital calculations, as those models need to backtest correctly and, hence, they need to follow the “real” measure, as opposed to the “risk-neutral” one. This paper shows evidence that the credit spreads of individual corporate names, by themselves, are not mean-reverting. Our results also suggest that a mean-reversion feature should be implemented in the context of joint spread-default modelling, but not in a spread-only model.