The Pricing of Correlated Default Risk

Abstract

Observed tranche spreads of a popular credit default swap (CDS) index reflect the pricing of portfolio credit risk, which we benchmark against “predicted” tranche spreads implied by the single-name CDS market. The overall levels and time profiles of the two sets of spreads reveal that the index and single-name markets are in agreement regarding the risk-neutral probabilities of default (PDs) associated with individual credit exposures. However, substantial tranche-specific differences between observed and predicted spreads suggest that the physical asset return correlations, which are extracted from the single-name market, are too low to account for prices of portfolio credit risk. We explain much of these differences via a correlation risk premium, which amounts on average to 66% of the physical correlations over our sample period.