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Default Correlations in the Merton Model

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  • Ulrich Erlenmaier
  • Hans Gersbach

Abstract

We examine the relationship between default probabilities and default correlations of two firms in the Merton model. We show that default correlations increase under a homogeneous increase of default probabilities. The same is true if the increase of the default probability is more pronounced for the firm with the lower likelihood of default. Default correlations may only decline if the increase of the default probability is significantly larger for the firm with higher default risk. These findings may have important implications for the assessment of credit portfolio risk, loan pricing, and capital requirements when adverse macroeconomic shocks occur.

Suggested Citation

  • Ulrich Erlenmaier & Hans Gersbach, 2014. "Default Correlations in the Merton Model," Review of Finance, European Finance Association, vol. 18(5), pages 1775-1809.
    • Handle: RePEc:oup:revfin:v:18:y:2014:i:5:p:1775-1809.
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    File URL: http://hdl.handle.net/10.1093/rof/rft030
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    References listed on IDEAS

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    Cited by:

    1. Weiping Li & Tim Krehbiel, 2016. "An Improved Approach To Evaluate Default Probabilities And Default Correlations With Consistency," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(05), pages 1-29, August.
    2. Mario Cerrato & John Crosby & Minjoo Kim & Yang Zhao, 2015. "Correlated Defaults of UK Banks: Dynamics and Asymmetries," Working Papers 2015_24, Business School - Economics, University of Glasgow.
    3. Dan Luo & Dragon Yongjun Tang & Sarah Qian Wang, 2018. "Model specification and collateralized debt obligation (mis)pricing," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 38(11), pages 1284-1312, November.
    4. Weiping Li, 2016. "Probability of Default and Default Correlations," JRFM, MDPI, vol. 9(3), pages 1-19, July.

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