Estimating asset correlations from stock prices or default rates--Which method is superior?
AbstractThis paper sets out to help explain why estimates of asset correlations based on equity prices tend to be considerably higher than estimates based on default rates. Resolving this empirical puzzle is highly important because, firstly, asset correlations are a key driver of credit risk and, secondly, both data sources are widely used to calibrate risk models of financial institutions. By means of a simulation study, we explore the hypothesis that differences in the correlation estimates are due to a substantial downward bias characteristic of estimates based on default rates. By varying the time horizon, the default probability, the asset correlation and the number of firms in the portfolio, we investigate these estimators in a systematic comparative study. Our results suggest that correlation estimates from equity returns are more efficient than those from default rates. This finding still holds if the model is misspecified such that asset correlations follow a Vasicek process which affects foremost the estimates from equity returns. The results lend support for the hypothesis that the downward bias of default-rate based estimates is an important although not the only factor to explain the differences in correlation estimates. Furthermore, our results help to quantify the estimation error of asset correlations dependent on the true values of default probability and asset correlation.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Economic Dynamics and Control.
Volume (Year): 34 (2010)
Issue (Month): 11 (November)
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Web page: http://www.elsevier.com/locate/jedc
Asset correlation Single risk factor model Small sample properties Structural model Basel II;
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- Düllmann, Klaus & Koziol, Philipp, 2013. "Evaluation of minimum capital requirements for bank loans to SMEs," Discussion Papers 22/2013, Deutsche Bundesbank, Research Centre.
- Hongbiao Zhao, 2011. "Portfolio credit risk of default and spread widening," LSE Research Online Documents on Economics 43451, London School of Economics and Political Science, LSE Library.
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