Asset Correlation , Realized Default Correlation , and Portfolio Credit Risk

Asset correlation is a critical driver in modeling portfolio credit risk. Despite its importance, there have been few studies on the empirical relationship between asset correlation and subsequently realized default correlation, and portfolio credit risk. This three three-way relationship is the focus of our study using U.S. public firm default data from 1981 to 2006. We find the magnitude of default-implied asset correlations is significantly higher than has been reported by other studies. There is a reasonably good agreement between our defaultimplied asset correlations and the asset correlation parameters in the Basel II Accord for large corporate borrowers. However, the recommended small size adjustment in the Basel II Accord still produces asset correlation higher than what we observe in our data. More importantly, we find that measuring asset correlation ex ante accurately can improve the measurement of subsequently realized default correlation and portfolio credit risk, in both statistical and economic terms. These results have several important practical implications for the calculation of economic and regulatory capital, and for pricing portfolio credit risk. Furthermore, the empirical framework that we developed in this paper can serve as a model validation framework for asset correlation models in measuring portfolio credit risk. AUTHORS Jing Zhang Fanlin Zhu Joseph Lee Copyright© 2008, Moody’s KMV Company. All rights reserved. Credit Monitor, CreditEdge, CreditEdge Plus, CreditMark, DealAnalyzer, EDFCalc, Private Firm Model, Portfolio Preprocessor, GCorr, the Moody’s KMV logo, Moody’s KMV Financial Analyst, Moody’s KMV LossCalc, Moody’s KMV Portfolio Manager, Moody’s KMV Risk Advisor, Moody’s KMV RiskCalc, RiskAnalyst, RiskFrontier, Expected Default Frequency, and EDF are trademarks owned by MIS Quality Management Corp. and used under license by Moody’s KMV Company. ACKNOWLEDGEMENTS We are extremely grateful to Douglas Dwyer, Stephanie Lee, Amnon Levy, Brain Ranson, and Charles Stewart for comments and suggestions. All remaining errors are, of course, our own. Published by: Moody’s KMV Company To contact Moody’s KMV, visit us online at www.moodyskmv.com. You can also contact Moody’s KMV through e-mail at [email protected], or call us by using the following phone numbers: NORTH AND SOUTH AMERICA, NEW ZEALAND, AND AUSTRALIA: 1 866 321 MKMV (6568) or 415 874 6000 EUROPE, THE MIDDLE EAST, AFRICA, AND INDIA: 44 20 7280 8300 ASIA-PACIFIC: 852 3551 3000 JAPAN: 81 3 5408 4250