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Default probabilities and default correlations

Author

Listed:
  • Erlenmaier, Ulrich
  • Gersbach, Hans

Abstract

Starting from the Merton framework for firm defaults, we provide the analytics and robustness of the relationship between default correlations. We show that loans with higher default probabilities will not only have higher variances but also higher correlations between loans. As a consequence, portfolio standard deviation can increase substantially when loan default probabilities rise. This result has two important implications. First, relative prices of loans with different default probabilities should reflect the differential impact on portfolio standard deviation. Second, the standard deviation of loan portfolios and of default rates, as well as the required economic capital will vary significantly over the business cycle.

Suggested Citation

  • Erlenmaier, Ulrich & Gersbach, Hans, 2001. "Default probabilities and default correlations," Research Notes 01-5, Deutsche Bank Research.
    • Handle: RePEc:zbw:dbrrns:015
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    File URL: https://www.econstor.eu/bitstream/10419/40256/1/341385050.pdf
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    Citations

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    Cited by:

    1. Palmroos, Peter, 2009. "Effects of unobserved defaults on correlation between probability of default and loss given on mortgage loans," Research Discussion Papers 3/2009, Bank of Finland.
    2. Ulrich Erlenmaier & Hans Gersbach, 2014. "Default Correlations in the Merton Model," Review of Finance, European Finance Association, vol. 18(5), pages 1775-1809.
    3. Sorge, Marco & Virolainen, Kimmo, 2006. "A comparative analysis of macro stress-testing methodologies with application to Finland," Journal of Financial Stability, Elsevier, vol. 2(2), pages 113-151, June.
    4. repec:zbw:bofrdp:2009_003 is not listed on IDEAS
    5. Palmroos, Peter, 2009. "Effects of unobserved defaults on correlation between probability of default and loss given on mortgage loans," Bank of Finland Research Discussion Papers 3/2009, Bank of Finland.
    6. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer;Western Finance Association, vol. 26(2), pages 161-191, October.
    7. Weiping Li, 2016. "Probability of Default and Default Correlations," JRFM, MDPI, vol. 9(3), pages 1-19, July.

    More about this item

    Keywords

    Credit portfolio management; Default correlations; Pricing of loans; Macroeconomic risk; Credit risk models;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • 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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