Credit Risk Models I: Default Correlation In Intensity Models

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Credit Risk Models I: Default Correlation In Intensity Models

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Abel Elizalde () (CEMFI, Centro de Estudios Monetarios y Financieros)

Abstract

This report analyzes reduced-from credit risk models, and reviews the three main approaches to incorporate credit risk correlation among firms within the framework of reduced models. The first approach, conditionally independent defaults (CID) models, introduces credit risk dependence of the firms' default intensity processes on a common set of state variables. Contagion models extend the CID approach to account for default clustering (periods in which the firms's credit risk is increased and in which the majority of the defaults take place). Finally, default dependecies can also be accounted for using copula functions. The copula approach takes as given the marginal default probabilities of the different firms and plugs them into a copula function, which provides the model with the default dependece structure. After a description of copulas, we present two different approaches of using copula functions in intensity models, and discuss the choice and calibration of the copula function.

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Paper provided by CEMFI in its series Working Papers with number wp2006_0605.

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Date of creation: Apr 2006
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Handle: RePEc:cmf:wpaper:wp2006_0605

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This paper has been announced in the following NEP Reports:

NEP-ALL-2006-10-07 (All new papers)
NEP-FMK-2006-10-07 (Financial Markets)
NEP-RMG-2006-10-07 (Risk Management)

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