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The pricing of correlated default risk: evidence from the credit derivatives market

  • Zhu, Haibin
  • Tarashev, Nikola A.

In order to analyze the pricing of portfolio credit risk – as revealed by tranche spreads of a popular credit default swap (CDS) index – we extract risk-neutral probabilities of default (PDs) and physical asset return correlations from single-name CDS spreads. The time profile and overall level of index spreads validate our PD measures. At the same time, the physical asset return correlations are too low to account for the spreads of index tranches and, thus, point to a large correlation risk premium. This premium, which covaries negatively with current realized correlations and positively with future realized correlations, sheds light on market perceptions of and attitude towards correlation risk.

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File URL: http://econstor.eu/bitstream/10419/19786/1/200809dkp_b_.pdf
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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 2: Banking and Financial Studies with number 2008,09.

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Date of creation: 2008
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Handle: RePEc:zbw:bubdp2:7319
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  1. Daniel 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. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
  3. Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
  4. Zhou, Chunsheng, 2001. "An Analysis of Default Correlations and Multiple Defaults," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 555-76.
  5. Darrel Duffie & Leandro Saita & Ke Wang, 2005. "Multi-Period Corporate Default Prediction With Stochastic Covariates," CARF F-Series CARF-F-047, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
  6. 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.
  7. repec:dgr:uvatin:2005060 is not listed on IDEAS
  8. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  9. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
  10. Koopman, Siem Jan & Lucas, André, 2008. "A Non-Gaussian Panel Time Series Model for Estimating and Decomposing Default Risk," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 510-525.
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