On Default Correlation: A Copula Function Approach

28 Pages Posted: 9 Dec 1999  

David X. Li

AIG Asset Management

Multiple version iconThere are 2 versions of this paper

Date Written: September 1999

Abstract

This paper studies the problem of default correlation. We first introduce a random variable called "time-until-default" to denote the survival time of each defaultable entity or financial instrument, and define the default correlation between two credit risks as the correlation coefficient between their survival times. Then we argue why a copula function approach should be used to specify the joint distribution of survival times after marginal distributions of survival times are derived from market information, such as risky bond prices or asset swap spreads. The definition and some basic properties of copula functions are given. We show that the current CreditMetrics approach to default correlation through asset correlation is equivalent to using a normal copula function. Finally, we give some numerical examples to illustrate the use of copula functions in the valuation of some credit derivatives, such as credit default swaps and first-to-default contracts.

JEL Classification: G12, G13, C41

Suggested Citation

Li, David X., On Default Correlation: A Copula Function Approach (September 1999). Available at SSRN: https://ssrn.com/abstract=187289 or http://dx.doi.org/10.2139/ssrn.187289

David Xianglin Li (Contact Author)

AIG Asset Management ( email )

80 Pine Street
New York, NY 10005
United States
+12127705384 (Phone)

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