Inferring Default Correlation from Equity Return Correlation

27 Pages Posted: 13 Mar 2015

See all articles by Sheen Liu

Sheen Liu

Washington State University - Vancouver

Howard Qi

Michigan Technological University; Independent

Jian Shi

Federal National Mortgage Association (Fannie Mae)

Yan Alice Xie

University of Michigan at Dearborn

Date Written: March 2015

Abstract

This paper presents a new approach for estimating default correlation by linking default correlation to equity return correlation while preserving the fundamental relation between default and asset correlations in the structural framework. Our hybrid model thus overcomes a long‐standing empirical difficulty that default correlation estimation relies on the unobservable asset process. The empirical analysis shows that our hybrid model demonstrates a considerable improvement over the existing structural model of Zhou (2001) for the sample periods of 1970‐1993 and 1990‐2010. We also illustrate the difference between the two models in predicting default correlations over the period of the 2008 financial crisis.

Keywords: Default correlation, equity (return) correlation, defaultable bonds, structural model

Suggested Citation

Liu, Sheen and Qi, Howard and Shi, Jian and Xie, Yan, Inferring Default Correlation from Equity Return Correlation (March 2015). European Financial Management, Vol. 21, Issue 2, pp. 333-359, 2015, Available at SSRN: https://ssrn.com/abstract=2577041 or http://dx.doi.org/10.1111/eufm.12016

Sheen Liu (Contact Author)

Washington State University - Vancouver ( email )

14204 NE Salmon Creek Ave.
Vancouver, WA 98686
United States

Howard Qi

Michigan Technological University ( email )

1400 Townsend Dr.
Houghton, MI 49931
United States

Independent ( email )

Jian Shi

Federal National Mortgage Association (Fannie Mae) ( email )

3900 Wisconsin Avenue, NW
Washington, DC 20016-2892
United States

Yan Xie

University of Michigan at Dearborn ( email )

Dearborn, MI
United States

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