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The Underlying Dynamics of Credit Correlations

Journal of Credit Risk, Vol. 3, No. 2, p. 27

37 Pages Posted: 6 Nov 2005 Last revised: 16 Jan 2012

Arthur M. Berd

General Quantitative, LLC; The Journal of Investment Strategies

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Artem B. Voronov

New York University (NYU) - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: April 30, 2007

Abstract

We propose a hybrid model of portfolio credit risk where the dynamics of the underlying latent variables is governed by a one factor GARCH process. The distinctive feature of such processes is that the long-term aggregate return distributions can substantially deviate from the asymptotic Gaussian limit for very long horizons. We introduce the notion of correlation surface as a convenient tool for comparing portfolio credit loss generating models and pricing synthetic CDO tranches. Analyzing alternative specifications of the underlying dynamics, we conclude that the asymmetric models with TARCH volatility specification are the preferred choice for generating significant and persistent credit correlation skews. The characteristic dependence of the correlation skew on term to maturity and portfolio hazard rate in these models has a significant impact on both relative value analysis and risk management of CDO tranches.

Keywords: credit risk, credit derivatives, credit correlation, downside risk, tail risk, time series, GARCH

JEL Classification: C22, G13

Suggested Citation

Berd, Arthur M. and Engle, Robert F. and Voronov, Artem B., The Underlying Dynamics of Credit Correlations (April 30, 2007). Journal of Credit Risk, Vol. 3, No. 2, p. 27. Available at SSRN: https://ssrn.com/abstract=837824 or http://dx.doi.org/10.2139/ssrn.837824

Arthur M. Berd (Contact Author)

General Quantitative, LLC ( email )

551 Madison Ave Suite 1202
New York, NY 10022
United States

The Journal of Investment Strategies ( email )

Haymarket House
28-29 Haymarket
London, SW1Y 4RX
United Kingdom

HOME PAGE: http://www.risk.net/type/journal/source/journal-of-investment-strategies

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Artem B. Voronov

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States

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