Default Correlation: an Empirical Approach
The default probability (PD) and default correlation are the key drivers for credit risk in a bank loan portfolio. While there exist many models for estimating the default probability there is still a lot of research to do for estimating the default correlation. The default correlation is a measure for the sensitivity of the PD to the systematic risk factor which represents the state of the economy. If two companies have a strong dependency on the same systematic risk factors then they have a higher default correlation. In the one- -factor risk model the correlation is a measure for the joint dependency of companies on one systematic risk factor The joint default probability is the probability that two companies default at the same time horizon. The new Basel Accord (Basel II) assumes that the correlation of a company with turnover between € 5 and € 50 million increases exponential to the size of the firm and that the default correlation decline with the PD. In this paper the correlation of 110 000 Austrian small and medium-sized enterprises (SME) will be estimated empirical with time series of defaults. The non-parametric probit ordered model by Gordy is used for the calculation of the asset correlation, After estimating the asset correlation it is possible to calculate the default correlation analytically. (fragment of text)
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