Correlation in Credit Risk
46 Pages Posted: 24 Mar 2009
Date Written: March 15, 2009
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: Suggested Citation