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In Rememberance: World Trade Center (WTC)

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Default Correlation: An Analytical Result

by Chunsheng Zhou of the Federal Reserve Board of Governors

May 1, 1997

Abstract: Evaluating default correlations and the probabilities of multiple defaults is an important task in credit analysis and risk management, but it has never been an easy one because default correlations cannot be measured directly. This paper provides, for the first time, an analytical formula for calculating default correlations based on a first-passage-time model which can be easily implemented and conveniently used in a variety of financial applications. The result of this paper also provides a theoretical justification for many empirical results found in the literature and increases our understanding of the important features of default correlations.

Keywords: Default correlation, first-passage-time.

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