Default Probabilities and Default Correlations

DefaultRisk.com the web's biggest credit risk modeling resource.

Submit Your Paper

Post Your Résumé

For Recruiters

Today's Featured Book

Modelling Extremal Events for Insurance and Finance
by Paul Embrechts, Claudia Klüppelberg, Thomas Mikosch, Springer, (October 15, 2004), Hardcover, 655 pages

Training Discounted for DefaultRisk.com visitors only:

The Mathematics of Credit Derivatives: The Essential Credit Modelling and Pricing Companion
by Philipp J. Schönbucher,
WBS Training, August 2003, DVD / Interactive CD-ROM

Sponsor:
Shop at Amazon.com and support DefaultRisk.com

Default Probabilities and Default Correlations

by Ulrich Erlenmaier of the University of Heidelberg, and
Hans Gersbach of the University of Heidelberg

November 2001

Abstract: Starting from the Merton framework for firm defaults, we provide the analytics and robustness of the relationship between default probabilities and default correlations. We show that loans with higher default probabilities will not only have higher variances but also higher correlations with other loans. As a consequence, portfolio standard deviations can increase substantially when loan default probabilities rise. This result has two important implications. First, relative prices of loans with different default probabilities should reflect the differential impact of portfolio standard deviation. Second, the standard deviation of loan portfolios and of default rates, as well as the required economic capital will vary significantly over the business cycle.

JEL Classification: G11, G12, G21, G31.

Keywords: Credit portfolio management, Default correlations, Pricing of loans, Macroeconomic risk, Credit risk models.

Books Referenced in this Paper: (what is this?)