Measuring Correlated Default Risk: A New Metric and Validity Tests

Posted: 20 Sep 2015 Last revised: 22 Jul 2017

See all articles by Siamak Javadi

Siamak Javadi

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American)

Seoyoung Kim

Santa Clara University

Tim Krehbiel

Oklahoma State University - Stillwater - Spears School of Business

Ali Nejadmalayeri

University of Wyoming - College of Business

Date Written: January 1, 2017

Abstract

Extracting information from daily CDS spreads, we propose a measure of correlated default risk, which we show is a meaningful predictor of bankruptcy clusters. Focusing on U.S. corporate bonds, we also find that our measure of correlated default risk is more pronounced and commands a higher premium during periods of financial distress and for speculative issues. For instance, we find that after controlling for other known determinants of bond pricing, a 0.5 increase in aggregate correlated default risk is associated with a 13-bps increase in credit spreads, and elevates to a 22-bps premium for speculative issues and to a 17-bps premium during periods of financial distress. Overall, our paper provides compelling evidence as to the efficacy of our measure in capturing correlations in the likelihood of default over time, and has important implications for future work in asset allocation and fixed-income pricing.

Keywords: correlated default risk, correlation in probability of default, credit default swap (CDS) spreads, credit spreads

JEL Classification: G01, G12, G13

Suggested Citation

Javadi, Siamak and Kim, Seoyoung and Krehbiel, Tim and Nejadmalayeri, Ali, Measuring Correlated Default Risk: A New Metric and Validity Tests (January 1, 2017). Journal of Fixed Income, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2662770 or http://dx.doi.org/10.2139/ssrn.2662770

Siamak Javadi

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American) ( email )

1201 W. University Dr.
Edinburg, TX 78539
United States

Seoyoung Kim (Contact Author)

Santa Clara University ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States

Tim Krehbiel

Oklahoma State University - Stillwater - Spears School of Business ( email )

201 Business
Stillwater, OK 74078-0555
United States

Ali Nejadmalayeri

University of Wyoming - College of Business ( email )

1000 E. University Avenue
Laramie, WY 82071
United States

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