Asset Correlation of German Corporate Obligors: Its Estimation, Its Drivers and Implications for Regulatory Capital (Paper presented at Basel Committee/Banca d'Italia workshop, 20-21 March 2003)

This paper addresses the gap between the theoretically well-understood impact of systematic risk on the loss-distribution of a credit-risky loan portfolio and the lack of empirical estimates of the default correlation. To this purpose we start with a one-factor model in which the correlation with the systematic risk factor equals the asset correlation between two firms. In the theoretical part of the paper the small sample performance of three different correlation estimators is analysed by Monte Carlo simulation. In the empirical part asset correlations are estimated from time series of ten years with default histories of 53280 German companies. The sample is divided into categories that are homogenous with respect to default probability (PD) and firm size. In this way we can explore to what extent correlations depend on these two factors. Several economic explanations why asset correlation depends on size and PD are discussed. The empirical analysis is motivated as well by current proposals for the internal rating based approaches of the new Basel Accord. They suggest that the asset correlation parameter in the formula for the risk weights depends on the PD and on the firm size of the obligor. Our empirical results are compared with this proposal.