A Comparative Empirical Study of Asset Correlations

by Jalal D. Akhavein of Fitch Ratings,
Ahmet E. Kocagil of Fitch Ratings, and
Matthias Neugebauer of Fitch Ratings

July 14, 2005

Summary: This study examines alternative approaches of empirical asset correlation modeling. In this context, we estimate and compare default correlation-based, rating transition-based, and equity-based methodologies.

Specifically, intra- and inter-industry asset correlations are estimated following the Fitch industry categorizations1 and the results are used to answer to following five questions:

1. Are the inter-industry asset correlation estimates equal to zero?
2. If not, would they become zero within a certain confidence bound?
3. Can we assume that inter-industry asset correlations are constant, e.g. x%?
4. Can we assume that intra-industry asset correlations are constant, e.g. z%?
5. Are the intra-industry correlations notably different (higher) than inter-industry asset correlations?

The empirical findings of the study show that: (a) inter-industry asset correlations are relatively smaller than intra-industry asset correlations, but they cannot be assumed to be zero, (b) intra-industry as well as inter-industry asset correlations vary across different industries, (c) there are notable empirical differences between intra-industry and inter-industry asset correlations, and in conjunction with that, (d) to the extent equity price movements tend to reflect some non-credit related information, correlations based on equity-based methods, especially those measuring inter-industry relationships are likely to be overestimated.

Default correlation analysis provides valuable insight; however, correlation methodologies based solely based on ratings data suffer from some shortcomings, as (1) ratings are predominantly U.S. based in coverage; thus, any inference based on ratings-based methods is likely to misrepresent the magnitude of correlations outside of North America by failing to capture regional differences, (2) the coverage of ratings is limited to a very small percentage of the corporate universe, and, (3) ratings-based methods cannot provide correlations beyond the ratings level, e.g. two firms of same rating class will have the same correlations irrespective of their firm specific characteristics.

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