Premia for Correlated Default Risk

31 Pages Posted: 25 Mar 2008 Last revised: 15 Jun 2016

See all articles by Kay Giesecke

Kay Giesecke

Stanford University - Management Science & Engineering

Shahriar Azizpour

Stanford University - Management Science & Engineering

Baeho Kim

Korea University Business School (KUBS)

Date Written: November 30, 2008

Abstract

Using data on corporate default experience in the U.S. and market rates of CDX index and tranche swaps of various maturities, we estimate reduced-form models of correlated default timing in the CDX High Yield and Investment Grade portfolios under actual and risk-neutral probabilities. The striking contrast between the estimated processes followed by the actual and risk-neutral arrival intensities of defaults, and between the parameters governing the actual and risk-neutral dynamics of the risk-neutral intensities, indicates the presence of substantial default risk premia in CDX swap market rates. The effects of risk premia on swap rates covary strongly across maturities, and depend on general stock market volatility and several measures of credit spreads. Large moves in the effects of these premia on swap rates have natural interpretations in terms of economic and financial market developments during the sample period, April 2004 to October 2007. Our results suggest that a large portion of the movements in CDX swap market rates observed during the sample period may be caused by changing attitudes towards correlated default risk rather than changes in the economic factors affecting the actual risk of clustered defaults, which ultimately governs swap payoffs.

Keywords: Correlated default, risk premium, intensity, feedback, contagion, frailty, swap, CDX, tranche, index

Suggested Citation

Giesecke, Kay and Azizpour, Shahriar and Kim, Baeho, Premia for Correlated Default Risk (November 30, 2008). Journal of Economic Dynamics and Control, Vol. 35, No. 8, pp. 1340-1357, 2011. Available at SSRN: https://ssrn.com/abstract=1126462 or http://dx.doi.org/10.2139/ssrn.1126462

Kay Giesecke (Contact Author)

Stanford University - Management Science & Engineering ( email )

473 Via Ortega
Stanford, CA 94305-9025
United States
(650) 723 9265 (Phone)
(650) 723 1614 (Fax)

HOME PAGE: http://www.stanford.edu/~giesecke/

Shahriar Azizpour

Stanford University - Management Science & Engineering ( email )

473 Via Ortega
Stanford, CA 94305-9025
United States

Baeho Kim

Korea University Business School (KUBS) ( email )

Anam-dong, Sungbuk-Gu
Korea University Business School
Seoul, 136-701
82-2-3290-2626 (Phone)
82-2-922-7220 (Fax)

HOME PAGE: http://biz.korea.ac.kr/~baehokim

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