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Credit Risk Models: An Analysis Of Default Correlation

Author

Listed:
  • Howard Qi
  • Yan Alice Xie
  • Sheen Liu

Abstract

This paper examines one of the major problems in credit risk models widely used in the financial industry to forecast future defaults and bankruptcies. We find that even after proper calibration, a representative credit risk model can severely underestimate default correlation. We further find that a likely reason for the underestimation of default correlation is the problematic common practice in the financial industry of using observable equity correlation as a proxy for unobservable asset correlation when the model is applied to predict default correlation. However, our results show that this proxy in common practice is not valid.

Suggested Citation

  • Howard Qi & Yan Alice Xie & Sheen Liu, 2010. "Credit Risk Models: An Analysis Of Default Correlation," The International Journal of Business and Finance Research, The Institute for Business and Finance Research, vol. 4(1), pages 37-49.
    • Handle: RePEc:ibf:ijbfre:v:4:y:2010:i:1:p:37-49
    as

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    References listed on IDEAS

    as
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    5. Kay Giesecke, 2003. "Successive Correlated Defaults: Pricing Trends and Simulation," Computing in Economics and Finance 2003 247, Society for Computational Economics.
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    More about this item

    Keywords

    Credit risk model; default correlation; model risk; financial crisis;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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