Journal of Credit Risk

Risk.net

The underlying dynamics of credit correlations

Arthur Berd, Robert Engle, Artem Voronov

ABSTRACT

We propose a hybrid model of portfolio credit risk where the dynamics of the underlying latent variables is governed by a one-factor GARCH process. The distinctive feature of such processes is that the long-term aggregate return distributions can substantially deviate from the asymptotic Gaussian limit for very long horizons. We introduce the notion of correlation surface as a convenient tool for comparing portfolio credit loss generating models and pricing synthetic CDO tranches. Analyzing alternative specifications of the underlying dynamics, we conclude that the asymmetric models with TARCH volatility specification are the preferred choice for generating significant and persistent credit correlation skews. The characteristic dependence of the correlation skew on term to maturity and portfolio hazard rate in these models has a significant impact on both relative value analysis and risk management of CDO tranches.

Sorry, our subscription options are not loading right now

Please try again later. Get in touch with our customer services team if this issue persists.

New to Risk.net? View our subscription options

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here