AN IMPROVED APPROACH TO EVALUATE DEFAULT PROBABILITIES AND DEFAULT CORRELATIONS WITH CONSISTENCY

Weiping Li and Tim Krehbiel ()
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Weiping Li: Southwest Jiaotong University, Chengdu, Sichuan Province 611756, P. R. China2Department of Finance, Oklahoma State University, Stillwater, Oklahoma 74078-4011, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 05, 1-29

Abstract: We provide (i) a simplified analytic closed form formula for evaluating joint default probability, (ii) an improved method to resolve the inconsistency between the univariate process underlying firm-specific default probability and the correlated bivariate process of the first-passage-time default correlation model, (iii) illustration of risk management implications from misspecification of the default state space. Our closed form formula provides a natural extension of previous structural first-passage-time models and shows the sensitivities of default correlation numerically with respect to the underlying asset correlation, obligor credit quality and time horizon. We emphasize the disparate credit risk management implications of our result in contrast to commonly used risk measurement methods.

Keywords: Default correlation; probability of default; consistency; credit analysis; risk management; Kolmogorov forward equation; first-passage-time model (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024916500369

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