Do We Need to Worry About Credit Risk Correlation?
by Abel Elizalde of CEMFI & Universidad Pública de Navarra
Abstract: Yes we do. This paper shows that any firm's credit risk is, to a very large extent, driven by common risk factors affecting all firms. Using a reduced form model and sequential Kalman filtering estimation we decompose the credit risk of a sample of corporate bonds (14 US firms, 2001-2003) into different unobservable risk factors. A single common factor accounts for more than 50% of all (but two) of the firms' credit risk levels, with an average of 68% across firms. This factor represents the credit risk levels underlying the US economy and is strongly correlated with main US stock indexes.
Keywords: Credit risk correlation, factor models.
Published in: Journal of Fixed Income, Vol. 15, No. 3, (December 2005), pp. 42-59.