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The Pricing of Correlated Default Risk

Evidence from the Credit Derivatives Market

Nikola Tarashev and Haibin Zhu
The Journal of Fixed Income Summer 2008, 18 (1) 5-24; DOI: https://doi.org/10.3905/jfi.2008.708840
Nikola Tarashev
A senior economist, Research and Policy Analysis at Bank for International Settlements in Basel, Switzerland.
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  • For correspondence: nikola.tarashev@bis.org
Haibin Zhu
A senior economist, Research and Policy Analysis at Bank for International Settlements in Basel, Switzerland.
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  • For correspondence: haibin.zhu@bis.org
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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.

TOPICS: Credit default swaps, credit risk management, statistical methods, analysis of individual factors/risk premia

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The Pricing of Correlated Default Risk
Nikola Tarashev, Haibin Zhu
The Journal of Fixed Income Jun 2008, 18 (1) 5-24; DOI: 10.3905/jfi.2008.708840

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The Pricing of Correlated Default Risk
Nikola Tarashev, Haibin Zhu
The Journal of Fixed Income Jun 2008, 18 (1) 5-24; DOI: 10.3905/jfi.2008.708840
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