Correlation in Corporate Defaults: Contagion or Conditional Independence?

41 Pages Posted: 25 Mar 2009 Last revised: 14 Dec 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: November 23, 2009

Abstract

We revisit a method used by Das, Duffie, Kapadia, and Saita (2007) (DDKS) to test the doubly stochastic assumption in intensity models of default. We show that using a different specification of the default intensity, and using the same test as DDKS, we cannot reject using an almost identical set of default histories recorded by Moody's in the period from 1982 to 2006. We propose additions to the procedure as well as a Hawkes process alternative to test for violations of conditional independence but cannot detect contagion. We then observe that the test proposed by DDKS is mainly a misspecification test in that it will not detect contagion effects as long as individual firms have default intensities and there are no simultaneous jumps to default. Specifically, contagion spread through the explanatory variables ('covariates') that determine the default intensities of individual firms will not be detected. We therefore perform different tests to see if firm-specific variables are affected by occurrences of defaults. Regression tests show that there is no influence from defaults on quick ratios, but some influence on distance-to-default.

Keywords: Default correlation, intensity estimation, Hawkes process

JEL Classification: G33, G32, C52

Suggested Citation

Lando, David and Nielsen, Mads Stenbo, Correlation in Corporate Defaults: Contagion or Conditional Independence? (November 23, 2009). AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1364357 or http://dx.doi.org/10.2139/ssrn.1364357

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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