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The pricing of portfolio credit risk

  • Nikola A. Tarashev
  • Haibin Zhu

Equity and credit-default-swap (CDS) markets are in disagreement as to the extent to which asset returns co-move across firms. This suggests market segmentation and casts ambiguity about the asset-return correlations underpinning observed prices of portfolio credit risk. The ambiguity could be eliminated by – currently unavailable – data that reveal the market valuation of low-probability/large-impact events. At present, judicious assumptions about this valuation can be used to reconcile observed prices with asset-return correlations implied by either equity or CDS markets. These conclusions are based on an analysis of tranche spreads of a popular CDS index, which incorporate a rather small premium for correlation risk.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 214.

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Length: 39 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:bis:biswps:214
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  1. Daniel M. Covitz & Song Han, 2004. "An empirical analysis of bond recovery rates: exploring a structural view of default," Finance and Economics Discussion Series 2005-10, Board of Governors of the Federal Reserve System (U.S.).
  2. John F. Geweke & Michael P. Keane, 1997. "Mixture of normals probit models," Staff Report 237, Federal Reserve Bank of Minneapolis.
  3. Siem Jan Koopman & Andr� Lucas & Robert Daniels, 2005. "A Non-Gaussian Panel Time Series Model for Estimating and Decomposing Default Risk," Tinbergen Institute Discussion Papers 05-060/4, Tinbergen Institute.
  4. Sanjiv Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2006. "Common Failings: How Corporate Defaults are Correlated," NBER Working Papers 11961, National Bureau of Economic Research, Inc.
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