CREDIT RISK MODELS: AN ANALYSIS OF DEFAULT CORRELATION

Howard Qi, Yan Alice Xie and Sheen Liu

The International Journal of Business and Finance Research, 2010, vol. 4, issue 1, 37-49

Abstract: This paper examines one of the major problems in credit risk models widely used in the financial industry to forecast future defaults and bankruptcies. We find that even after proper calibration, a representative credit risk model can severely underestimate default correlation. We further find that a likely reason for the underestimation of default correlation is the problematic common practice in the financial industry of using observable equity correlation as a proxy for unobservable asset correlation when the model is applied to predict default correlation. However, our results show that this proxy in common practice is not valid.

Keywords: Credit risk model; default correlation; model risk; financial crisis (search for similar items in EconPapers)
JEL-codes: G01 G21 G31 (search for similar items in EconPapers)
Date: 2010
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Persistent link: https://EconPapers.repec.org/RePEc:ibf:ijbfre:v:4:y:2010:i:1:p:37-49

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