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In Rememberance: World Trade Center (WTC)

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Modelling Default Correlation in Bond Portfolios

by Mark Davis of Vienna University of Technology, and
Violet Lo of Tokyo-Mitsubishi International, plc.

October 2, 2001

Abstract: The performance of a CBO structure is critically dependent on the correlation of defaults in a medium-sized portfolio of bonds. We introduce two classes of purely probabilistic models to handle these interaction effects. In the first, we suppose that default of an issuer in a particular industry sector may trigger off defaults of other issuers in the same sector by an 'infection' mechanism. As infection increases we find that the default distribution has increased variance and heavier tails, quantifying the concentration risk. The second model is a continuous-time stochastic process called an enhanced-risk model, that exhibits very similar features. In this case the incremental default probability is increased for all other issuers for a certain random period following occurrence of a default. The paper concludes with some comments on parameter estimation and applications of these models in CBO analysis.

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