This paper sets out to help explain why estimates of asset correlations based on equity prices tend to be considerably higher than estimates based on default rates. Resolving this empirical puzzle is highly important because, firstly, asset correlations are a key driver of credit risk and, secondly, both data sources are widely used to calibrate risk models of financial institutions. By means of a simulation study, we explore the hypothesis that differences in the correlation estimates are due to a substantial downward bias characteristic of estimates based on default rates. Our results suggest that correlation estimates from equity returns are more efficient than those from default rates. This finding still holds if the model is misspecified such that asset correlations follow a Vasicek process which affects foremost the estimates from equity returns. The results lend support for the hypothesis that the downward bias of default-rate based estimates is an important although not the only factor to explain the differences in correlation estimates. Furthermore, our results help to quantify the estimation error of asset correlations dependent on the risk characteristics of the underlying data base.Keywords: Asset correlation, single risk factor model, small sample properties, structural model, Basel II JEL Classification: G 21, G 33, C 13 Non-Technical SummaryDefault dependencies between borrowers are a key driver of credit risk in loan portfolios. Such dependencies are commonly measured by asset correlations between firms' asset-value returns. Since asset returns are not observable, these correlations are often estimated from time series of stock returns or historical default rates. Both approaches have yielded quite different results in the literature. Since empirical studies use different samples it has not been possible to reconcile these differences. In this paper we explore the hypothesis that the observed differences are explainable by the properties of the statistical methods of parameter estimation which differ between an estimation from stock returns and an estimation from default rates. A confirmation of this hypothesis can give risk managers guidance with selecting the appropriate data source for the estimation of asset correlations. In order to verify the hypothesis we apply a comprehensive simulation study with a multitude of risk parameters and credit portfolios of different size. We find that statistical methods play an important role in explaining the differences between asset correlation estimates from stock prices and from default rates. It is generally recommendable to use stock prices for the estimation as the statistical errors are substantially smaller in this case. This observation still holds if the model is misspecified such that the asset correlations are not constant over time as assumed by the model but follow a stochastic process. Nichttechnische Zusammenfassung
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