Measuring Correlated Default Risk: A New Metric and Validity Tests

48 Pages Posted: 20 Sep 2015 Last revised: 4 Feb 2017

Siamak Javadi

California Polytechnic State University

Seoyoung Kim

Santa Clara University

Tim Krehbiel

Oklahoma State University - Stillwater - Spears School of Business

Ali Nejadmalayeri

Oklahoma State University - Department of Finance; Oklahoma State University, Stillwater - Spears School 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). Available at SSRN: https://ssrn.com/abstract=2662770 or http://dx.doi.org/10.2139/ssrn.2662770

Siamak Javadi

California Polytechnic State University ( email )

411 Orfalea College of Business
San Luis Obispo, CA 93407
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

Oklahoma State University - Department of Finance ( email )

College of Business Administration
North Hall Room 305
Tulsa, OK 74106
United States
918-594-8399 (Phone)
918-594-8281 (Fax)

HOME PAGE: http://spears.okstate.edu/profiles/?id=241

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

201 Business
Stillwater, OK 74078-0555
United States
(918) 594-8399 (Phone)
(918) 594-8281 (Fax)

HOME PAGE: http://spears.okstate.edu/profiles/?id=241

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