Exploring Dynamic Default Dependence

43 Pages Posted: 7 May 2009

See all articles by Peter Christoffersen

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; Aarhus University - CREATES

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Xisong Jin

Central Bank of Luxembourg

Date Written: April 30, 2009

Abstract

Characterizing the dependence between companies’ defaults is a central problem in the credit risk literature, and the dependence structure is a first order determinant of the value of credit portfolios and structured credit products such as collateralized debt obligations (CDO), as well as the relative values of CDO tranches. We compare correlation measures implied by CDO prices with time-varying correlations implied by equity returns and CDS spreads. We use flexible dynamic equicorrelation techniques introduced by Engle and Kelly (2008) to capture time variation in CDS-implied and equity return-implied correlations. We perform this analysis using North American firms from the CDX index, as well as European firms from the iTraxx index. All correlation time series are highly time-varying and persistent, and correlations extracted from CDSs and CDOs increased significantly in European and North American markets during the turbulent second half of 2007. Interestingly, we find that the correlation time-series implied by CDO prices co-moves very strongly with the correlation time-series extracted from CDS spreads, but somewhat less strongly with the correlations between equity returns. These findings suggest that the cross-sectional dependence in these complex structured products is fairly well measured. However, changes in CDO prices may be due to changes in correlation, and more sophisticated models with time-varying correlations are thus needed to value CDOs.

Keywords: credit risk, structured products, dynamic equicorrelation, CDS, CDO, default

JEL Classification: G12

Suggested Citation

Christoffersen, Peter and Ericsson, Jan and Jacobs, Kris and Jin, Xisong, Exploring Dynamic Default Dependence (April 30, 2009). Available at SSRN: https://ssrn.com/abstract=1400427 or http://dx.doi.org/10.2139/ssrn.1400427

Peter Christoffersen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Xisong Jin

Central Bank of Luxembourg ( email )

2, boulevard Royal
Luxembourg, L-2983
Luxembourg
(+352) 4774 4462 (Phone)
(+352) 4774 4902 (Fax)

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