Inferring Asset Correlations from CDS Spreads: A Structural Model Approach

The Review of Asset Pricing Studies, Forthcoming

Midwest Finance Association 2013 Annual Meeting Paper

30 Pages Posted: 30 Aug 2012 Last revised: 4 Dec 2014

See all articles by Chanatip Kitwiwattanachai

Chanatip Kitwiwattanachai

University of Connecticut

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: August 29, 2012

Abstract

Default correlation is a concern especially after witnessing the financial crisis. To find default correlations, we would like to know asset correlations which are unobservable. In this paper we derive a model to infer asset correlations from Credit Default Swaps (CDSs). We use a structural model approach with the first passage time as default. The resulting model is closed-form and extremely easy to compute. Using the data from 2004 to 2008, we find the average implied asset correlation from CDS to be over 0.4. The average equity correlation, which is usually used as a proxy for asset correlation, over the same period is 0.155. The result complies with the literature that there is another unobservable factor driving defaults among firms.

Suggested Citation

Kitwiwattanachai, Chanatip and Pearson, Neil D., Inferring Asset Correlations from CDS Spreads: A Structural Model Approach (August 29, 2012). The Review of Asset Pricing Studies, Forthcoming, Midwest Finance Association 2013 Annual Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2138448 or http://dx.doi.org/10.2139/ssrn.2138448

Chanatip Kitwiwattanachai (Contact Author)

University of Connecticut ( email )

Department of Finance
Storrs, CT 06269-1063
United States

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)

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