Firm Defaults and the Correlation Effect

Abstract

We examine how the correlations of bank loan defaults depend on the correlations of asset returns and how correlations and diversification are affected by macroeconomic risks. We highlight the main properties of the relationship between asset returns and default correlations, illustrating how adverse macroeconomic shocks raise not only the likelihood of defaults, but also the correlation of defaults. The latter effect, called correlation effect, may account for more than 50% of the increase in the credit risk. Copyright Blackwell Publishing Ltd 2003.

A comparative analysis of macro stress-testing methodologies with application to Finland

“…Ceteris paribus, higher volatilities and correlations in an adverse macroeconomic environment may translate into a conditional loss distribution with fatter tails. Gersbach and Lipponer (2003) estimate that a substantial share of the increase in credit risk (the shift from point VaR 1 to VaR 2 in Fig. 3) is due to the widening of the tail (correlation and volatility effects), as opposed to the parallel shift to the right of the whole distribution (which captures the translation of the mean).…”

“…A first step in order to make this problem more tractable, especially from an empirical perspective, is to move from the concept of default volatility/correlation to the notion of Source: Adapted from Gersbach and Lipponer (2003). For given asset correlation and rating (i.e.…”

The determinants of bank loan recovery rates

“…Business cycles, not surprisingly, are also linked to the probability of default (Gersbach and Lipponer, 2003). Frye (2000) fits his model to Moody's data on US corporate bonds and estimates that recoveries decline by 20-25% during downturns relative to normal-year recoveries.…”

Credit risk drivers: Evaluating the contribution of firm level information and of macroeconomic dynamics

“…In the second group of models (those which rely mostly on market information), we can include Merton-type approaches to credit risk modelling 1 (see, for instance, Tudela andYoung, 2003, Gersbach andLipponer, 2003 or even Moody's KMV model, 2004), as well as other modelling setups, such as Jarrow and Turnbull (1995), Shumway (2001) or Couderc and Renault (2005). The major drawback of such models is that, as they rely on market information, usually they can only be applied to quoted companies.…”