Correlated Default Risk
by Sanjiv R. Das of Santa Clara University
Laurence Freed of Bear Sterns,
Gary Geng of Amaranth Group, Inc., and
Nikunj Kapadia of the University of Massachusetts
Abstract: Recently, an unusually high number of firms in the economy defaulted, with the default rate for Moody's-rated speculative grade issuers reaching as high as 10.2% in 2001.
In their annual review, Moody's summarized these credit events as follows, "Record defaults --unmatched in number and dollar volume since the Great Depression-- have culminated in the bankruptcies of well-known firms whose rapid collapse caught investors by surprise." What factors cause the economy-wide default rate to change over time, and why does it vary as much as it does? In this article, we investigate the likelihood of joint default across firms in the economy by examining the covariation of individual firms' default probabilities. This, in turn, provides insight into how, and why, the economy-wide default rate varies over time.
Keywords: Correlated default, hazard rates, credit risk.
Published in: Journal of Fixed Income, Vol. 16, No. 2, (September 2006), pp. 7-32.
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