Correlation in Credit Risk

46 Pages Posted: 24 Mar 2009

See all articles by Xinlei Shelly Zhao

Xinlei Shelly Zhao

Government of the United States of America - Office of the Currency Comptroller - Risk Analysis Division

Xiaoling Pu

Kent State University - Department of Finance

Date Written: March 15, 2009

Abstract

We examine the correlation in credit risk using the credit default swap (CDS) data. We find that a linear combination of the observable risk factors at the firm, industry, and market levels and the macroeconomic variables leaves about one-third of the correlation in CDS spread changes unaccounted for. However, inclusion of higher order and interactive terms of these factors can completely eliminate the residual correlation in credit risk. This finding suggests that the doubly stochastic assumption may be proper in general. Further, consistent with some theoretical predictions, we find that the correlation is counter-cyclical and is also higher among low credit rating firms than among high credit rating firms. This finding does not render support to the recommendations in Basel II.

Keywords: Correlations, credit risk, credit spread, macroeconomic conditions, industry effect

JEL Classification: G28, G33

Suggested Citation

Zhao, Xinlei and Pu, Xiaoling, Correlation in Credit Risk (March 15, 2009). Available at SSRN: https://ssrn.com/abstract=1360503 or http://dx.doi.org/10.2139/ssrn.1360503

Xinlei Zhao

Government of the United States of America - Office of the Currency Comptroller - Risk Analysis Division ( email )

250 E Street, SW
Washington, DC 20219
United States

Xiaoling Pu (Contact Author)

Kent State University - Department of Finance ( email )

College of Business Administration
P.O. Box 5190
Kent, OH 44242-0001
United States

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