Correlation in Credit Risk Xiaoling Pu Xinlei Zhao Office of the Comptroller of the Currency OCC Economics Working Paper 2009-5 Version Date: February 2, 2010 Keywords: Correlations, credit risk, credit spread, macroeconomic conditions, industry effect. JEL Classifications: G28, G33. Xiaoling Pu is an Assistant Professor in the Department of Finance, Kent State University; Xinlei Zhao is a Financial Economist in the Credit Risk Analysis Division at the Office of the Comptroller of the Currency and an Associate Professor in the Department of Finance, Kent State University. Please address correspondence to Xinlei Zhao, Office of the Comptroller of the Currency, 250 E St. SW, Washington, DC 20219 (phone: 202-927-9960; e-mail: firstname.lastname@example.org). The views expressed in this paper are those of the
authors alone and do not necessarily reflect those of the Office of the Comptroller of the Currency or the U.S. Department of the Treasury. The authors would like to thank Min Qi, Paul Dawson, and participants of the 2009 Asian Financial Management Association meeting and research seminars at Kent State University and the Office of the Comptroller of the Currency for their insightful comments and editorial assistance. The authors take responsibility for any errors. i Correlation in Credit Risk Xiaoling Pu Xinlei Zhao February 2010 Abstract: We examine the correlation in credit risk using credit default swap (CDS) data. We find that the observable risk factors at the firm, industry, and market levels and the macroeconomic variables cannot fully explain the correlation in CDS spread changes, leaving at least 30 percent of the correlation unaccounted for. This finding suggests that contagion is not only statistically but also economically significant in causing correlation in credit risk. Thus, it is important to incorporate an unobservable risk factor into credit risk models in future research. We also find, consistent with some theoretical predictions, that the correlation is countercyclical and is higher among firms with low credit ratings than among firms with high credit ratings. I. Introduction Correlation in credit risk is a well-known phenomenon. Understanding the causes of correlated credit losses is crucial for many purposes, such as managing a portfolio, setting capital requirements for banks, and pricing structured credit products that are heavily exposed to correlations in credit risk; for example, collateralized debt obligations (CDO). This issue has become particularly important because of the rapid growth of structured credit products in the financial markets in recent years. But despite much research on the subject, we do not understand many aspects of correlation in credit risk; this paper attempts to move the literature forward. First, we explore the economic importance of contagion in credit risk correlation. This is an open empirical question. Many credit models are based on the doubly stochastic assumption that, conditional on observable risk factors, defaults are independent of each other. This assumption is widely accepted and implemented in banking to determine capital requirements. However, the assumption has been challenged by Das and colleagues (2007), and their findings are supported by Duffie and colleagues (2008). Evidence exists that contagion has a notable impact on the correlation in credit risk of firms subject to significant credit events (Jorion and Zhang 2007)....
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