The Empirical Relation between Credit Quality, Recovery, and Correlation

HKIMR Working Paper No.22/2009

38 Pages Posted: 3 Sep 2009

See all articles by Daniel Roesch

Daniel Roesch

University of Regensburg

Harald (Harry) Scheule

University of Technology Sydney (UTS) - School of Finance and Economics; Financial Research Network

Date Written: July 31, 2009

Abstract

The majority of industry credit portfolio risk models, as well as recent scientific results, are based on isolated modules for default probabilities and recoveries in the event of default. This paper shows that these common methods lead to various econometric drawbacks when the parameters are interpreted and aggregated for risk capital allocation and pricing purposes.

This paper provides a top down approach in which individual credit risk parameters are derived analytically from a single model. This model allows for a i) dynamic, ii) consistent, and iii) unbiased modeling of credit portfolio risks. An empirical analysis provides evidence for the inferred relationship between credit quality, recovery and correlation.

Keywords: Asset Value, Correlation, Credit Portfolio, Loss Given Default, Merton Model, Probability of Default, Recovery, Volatility

JEL Classification: G20, G28, C51

Suggested Citation

Roesch, Daniel and Scheule, Harald, The Empirical Relation between Credit Quality, Recovery, and Correlation (July 31, 2009). HKIMR Working Paper No.22/2009, Available at SSRN: https://ssrn.com/abstract=1466600 or http://dx.doi.org/10.2139/ssrn.1466600

Daniel Roesch

University of Regensburg ( email )

Chair of Statistics and Risk Management
Faculty of Business, Economics and BIS
Regensburg, 93040
Germany

HOME PAGE: http://www-risk.ur.de/

Harald Scheule (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

P.O. Box 123
Broadway, NSW 2007
Australia

HOME PAGE: http://https://www.uts.edu.au/staff/harald.scheule

Financial Research Network ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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