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Debt Correlations in the Wake of the Financial Crisis: What are Appropriate Default Correlations for Structured Products?

62 Pages Posted: 21 Nov 2014 Last revised: 21 May 2016

John M. Griffin

University of Texas at Austin - Department of Finance

Jordan Nickerson

Boston College

Date Written: May 20, 2016

Abstract

This paper proposes several frameworks to estimate the appropriate default correlations for structured products, each of which jointly considers the role of co-movements in modeled risk characteristics and un-modeled systematic risk, or 'frailty'. We contrast our estimates with credit rating agencies' default correlation assumptions, which were only 0.01 for CLOs pre-crisis and have increased to 0.03 post-crisis. In contrast, the joint consideration of observable risk factors and frailty leads to substantially higher estimates of 0.12. We show that this translates into CLOs with credit risk understated by more than 22%, suggesting caution for the post-crisis structured finance market.

Keywords: Credit Ratings, Financial Crises, Structured Finance, Default Correlations

JEL Classification: G14, G24, G28, G32

Suggested Citation

Griffin, John M. and Nickerson, Jordan, Debt Correlations in the Wake of the Financial Crisis: What are Appropriate Default Correlations for Structured Products? (May 20, 2016). Available at SSRN: https://ssrn.com/abstract=2528180 or http://dx.doi.org/10.2139/ssrn.2528180

John Griffin

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-471-6621 (Phone)

HOME PAGE: http://www.jgriffin.info

Jordan Nickerson (Contact Author)

Boston College ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

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