Default probabilities and default correlations

Arbeitspapier

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.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Research Notes ; No. 01-5

Classification and Topics

• Classification: Wirtschaft ; Portfolio Choice; Investment Decisions ; Asset Pricing; Trading Volume; Bond Interest Rates ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Capital Budgeting; Fixed Investment and Inventory Studies; Capacity
• Subject: Credit portfolio management ; Default correlations ; Pricing of loans ; Macroeconomic risk ; Credit risk models ; Kreditrisiko ; Portfolio-Management ; Optionspreistheorie ; Theorie ; Varianzanalyse ; Korrelation

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Erlenmaier, Ulrich ; Gersbach, Hans
• Event: Veröffentlichung
• (who): Deutsche Bank Research
• (where): Frankfurt a. M.
• (when): 2001

Further information

• Handle: http://hdl.handle.net/10419/40256
• Last update: 10.03.2025, 11:42 AM CET