Asset correlations and procyclical impact

Kung-Cheng Ho, Jiun-Lin (Alex) Chen and Shih-Cheng Lee

Journal of Risk Model Validation

Abstract: We examine the behavior of asset correlations for companies in Taiwan under the Basel Accord’s asymptotic single-risk-factor approach. Using Merton’s model to estimate a firm’s probability of default (PD) from 1990 to 2013, we find that asset correlations are positively correlated with firm size and negatively correlated with PD. We also find an industry effect, where, on average, firms in basic materials and technology industries have higher asset correlations. Most importantly, we confirm that asset correlations are asymmetric and have a procyclical impact on the real economy after these effects are controlled. They tend to decline during economic upturns and rise during economic downturns. In addition, the average decrease is smaller than the increase. Our findings provide important policy implications for future regulatory frameworks, as asset correlations may be underestimated during economic downturns.

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