On the Basel Accord’s Inverse Relationship between Default Probability and Asset Correlation: An Empirical Study

Abstract

The Basel Accord assumes an inverse relationship between the probability of default and the asset correlation parameter, with the latter being responsible for modeling the degree of cyclicality of default rates. Previous empirical studies that embedded the formula of the Basel Accord into a statistical model, however, were not able to support this relationship. In this article, we find evidence for the inverse relationship between default probability and asset correlation. By replicating the results from previous studies, we provide an explanation for the different findings. Finally, we propose a parametric function to model the relationship between the default probability and the asset correlation.

TOPICS: Fixed income and structured finance, statistical methods