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Inferring Default Correlation from Equity Return Correlation


  • We thank an anonymous referee, John Doukas (the editor), Chunchi Wu at the SUNY Buffalo, and participants at the European Financial Management 2009 Symposium on Risk Management in Financial Institutions and the Financial Management Association 2010 Meeting for valuable comments. We also thank the University of Michigan-Dearborn for financial support. Sheen Liu would like to thank the support from the National Science Foundation of China (No. 71071027). The authors are responsible for the contents of the publication. Correspondence: Yan Alice Xie


This paper presents a new approach for estimating default correlation by linking default correlation to equity return correlation while preserving the fundamental relation between default and asset correlations in the structural framework. Our hybrid model thus overcomes a long-standing empirical difficulty that default correlation estimation relies on the unobservable asset process. The empirical analysis shows that our hybrid model demonstrates a considerable improvement over the existing structural model of Zhou (2001) for the sample periods of 1970-1993 and 1990-2010. We also illustrate the difference between the two models in predicting default correlations over the period of the 2008 financial crisis.

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