Correlation in Corporate Defaults: Contagion or Conditional Independence?

40 Pages Posted: 6 Feb 2009

See all articles by David Lando

David Lando

Copenhagen Business School

Mads Stenbo Nielsen

Copenhagen Business School - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: February 5, 2009

Abstract

We revisit a test for conditional independence in intensity models of default proposed by Das, Duffie, Kapadia, Saita (2007) (DDKS). Based on a sample of US corporate defaults, they reject the conditional independence assumption but also observe that the test is a joint test of the specification of the default intensity of individual firms and the assumption of conditional independence. We show that using a different specification of the default intensity, and using the same test as DDKS, we cannot reject the assumption of conditional independence for default histories recorded by Moody's in the period from 1982 to 2006. We also show, that the test proposed by DDKS is not able to detect all violations of conditional independence. Specifically, the tests will not capture contagion effects which are spread through the explanatory variables ('covariates') used as conditioning variables in the Cox regression and which determine the default intensities of individual firms. We therefore perform different tests to see if firm-specific variables, i.e quick ratios and distance-to-default, are affected by defaults. We find no influence from defaults on Quick ratios, but some influence on distance-to-default. This suggests, that violations of conditional independence do indeed arise from balance sheet effects.

Keywords: Default correlation, intensity estimation, Hawkes

JEL Classification: G33, G32, C52

Suggested Citation

Lando, David and Nielsen, Mads Stenbo, Correlation in Corporate Defaults: Contagion or Conditional Independence? (February 5, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1338381 or http://dx.doi.org/10.2139/ssrn.1338381

David Lando (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark
+45 3815 3600 (Fax)

Mads Stenbo Nielsen

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark
+4538153602 (Phone)

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