Chapter

Default Correlation in Intensity Models for Credit Risk Modeling

Credit Risk Modeling

  1. Abel Elizalde PhD

Published Online: 15 DEC 2012

DOI: 10.1002/9781118182635.efm0024

Encyclopedia of Financial Models

Encyclopedia of Financial Models

How to Cite

Elizalde, A. 2012. Default Correlation in Intensity Models for Credit Risk Modeling. Encyclopedia of Financial Models. .

Author Information

  1. Credit Derivatives Strategy, J.P. Morgan

Publication History

  1. Published Online: 15 DEC 2012

Abstract

The two primary types of credit risk models that seek to statistically describe default processes are the reduced-form model and the structural model. The most extended types of reduced-form models are the intensity models. There are three main approaches to incorporate credit risk correlation among firms within the framework of reduced models. The first approach, the conditionally independent defaults models, introduces credit risk dependence among firms through the dependence of the firms’ default intensity processes on a common set of state variables. Contagion models extend the conditionally independent defaults approach to account for default clustering (periods in which the firms’ credit risk is increased and in which the majority of the defaults take place). Finally, default dependencies can also be accounted for using copula functions. The copula approach takes as given the marginal default probabilities of the different firms and plugs them into a copula function, which provides the model with the default dependence structure.

Keywords:

  • reduced-form;
  • intensity;
  • models;
  • default correlation;
  • contagion models;
  • copula functions;
  • default clustering