An Analysis of Default Correlations and Multiple Defaults

Evaluating default correlations or the probabilities of default by more than one firm is an important task in credit analysis, derivatives pricing, and risk management. However, default correlations cannot be measured directly, multiple-default modeling is technically difficult, and most existing credit models cannot be applied to analyze multiple defaults. This article develops a first-passage-time model, providing an analytical formula for calculating default correlations that is easily implemented and conveniently used for a variety of financial applications. The model also provides a theoretical justification for several empirical regularities in the credit risk literature. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

[1]  H. Leland..  Agency Costs, Risk Management, and Capital Structure , 1998 .

[2]  S. P. Mason,et al.  Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation , 1984, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[3]  Eduardo S. Schwartz,et al.  A Simple Approach to Valuing Risky Fixed and Floating Rate Debt , 1995 .

[4]  J. Harrison,et al.  Brownian motion and stochastic flow systems , 1986 .

[5]  D. Duffie,et al.  Modeling term structures of defaultable bonds , 1999 .

[6]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[7]  H. Leland.,et al.  Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads , 1996, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[8]  F. Black,et al.  VALUING CORPORATE SECURITIES: SOME EFFECTS OF BOND INDENTURE PROVISIONS , 1976 .

[9]  Chunsheng Zhou,et al.  The term structure of credit spreads with jump risk , 2001 .

[10]  G. Duffee.  Estimating the Price of Default Risk , 1996 .

[11]  R. C. Merton,et al.  On the Pricing of Corporate Debt: The Risk Structure of Interest Rates , 1974, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[12]  H. D. Miller,et al.  The Theory Of Stochastic Processes , 1977, The Mathematical Gazette.

[13]  Jerome S. Fons.  Using Default Rates to Model the Term Structure of Credit Risk , 1994 .

[14]  Douglas J. Lucas.  Default Correlation and Credit Analysis , 1995 .

[15]  Ioannis Karatzas,et al.  Brownian Motion and Stochastic Calculus , 1987 .