The Correlation Effect

Abstract

We examine how the correlations of bank loan defaults depend on the correlations of asset returns and how correlations and diversification are affected by macroeconomic risks. We highlight the main properties of the relationship between asset returns and default correlations, illustrating how adverse macroeconomic shocks raise not only the likelihood of defaults, but also the correlation of defaults. The latter effect, called "correlation effect", may account for more than 50% of the increase in the credit risk.

Keywords: Credit portfolio management, default correlations, macroeconomic shocks, correlation effect, Monte-Carlo Simulation

JEL Classification: F47, G11, G33