The Pricing of Portfolio Credit Risk

Tarashev, Nikola A.; Zhu, Haibin

doi:10.2139/ssrn.926334

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The Pricing of Portfolio Credit Risk

BIS Working Paper No. 214

39 Pages Posted: 20 Sep 2007

See all articles by Nikola A. Tarashev

Nikola A. Tarashev

Bank for International Settlements (BIS) - Monetary and Economic Department

Haibin Zhu

Bank for International Settlements (BIS)

Date Written: September 2006

Abstract

Equity and credit-default-swap (CDS) markets are in disagreement as to the extent to which asset returns co-move across firms. This suggests market segmentation and casts ambiguity about the asset-return correlations underpinning observed prices of portfolio credit risk. The ambiguity could be eliminated by - currently unavailable - data that reveal the market valuation of low-probability/large-impact events. At present, judicious assumptions about this valuation can be used to reconcile observed prices with asset-return correlations implied by either equity or CDS markets. These conclusions are based on an analysis of tranche spreads of a popular CDS index, which incorporate a rather small premium for correlation risk.

Keywords: CDS index tranche, Joint distribution of asset returns, Correlation risk premium, Copula

JEL Classification: G13, C15

Suggested Citation: Suggested Citation

Tarashev, Nikola A. and Zhu, Haibin, The Pricing of Portfolio Credit Risk (September 2006). BIS Working Paper No. 214, Available at SSRN: https://ssrn.com/abstract=926334 or http://dx.doi.org/10.2139/ssrn.926334