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Default probabilities and default correlations

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Starting from the Merton framework for firm defaults, we provide the analytics and robustness of the relationship between default correlations. We show that loans with higher default probabilities will not only have higher variances but also higher correlations between loans. As a consequence, portf...

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Bibliographic Details
Main Authors: Erlenmaier, Ulrich (Author) , Gersbach, Hans (Author)
Format: Book/Monograph Working Paper
Language:English
Published: Frankfurt a. M. Deutsche Bank Research 2001
Edition:First Version: April 2000, This Version: October 2001
Series:Research notes in economics & statistics 01-5
In: Research notes in economics & statistics (01-5)

Subjects:
Graue Literatur
Arbeitspapier
Online Access:Resolving-System, kostenfrei, Volltext: http://hdl.handle.net/10419/40256
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Author Notes:Ulrich Erlenmaier and Hans Gersbach

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520 |a Starting from the Merton framework for firm defaults, we provide the analytics and robustness of the relationship between default correlations. We show that loans with higher default probabilities will not only have higher variances but also higher correlations between loans. As a consequence, portfolio standard deviation can increase substantially when loan default probabilities rise. This result has two important implications. First, relative prices of loans with different default probabilities should reflect the differential impact on portfolio standard deviation. Second, the standard deviation of loan portfolios and of default rates, as well as the required economic capital will vary significantly over the business cycle. 
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