Premia for Correlated Default Risk

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Premia for Correlated Default Risk

by Shahriar Azizpour of Stanford University, and
Kay Giesecke of Stanford University

April 28, 2008

Abstract: Credit investors are exposed to correlated changes in issuers' conditional default rates that are due to movements in common risk factors, and the feedback jumps in default rates that are caused by the impact of a default event on the surviving firms. This article explores the risk premia investors require for bearing that exposure during April 2004--October 2007. We develop and estimate from an extensive data set of corporate defaults and market rates of CDX High Yield and Investment Grade index and tranche swaps a self-exciting model of correlated firm default under actual and risk-neutral probabilities. Our likelihood estimators indicate that CDX investors require substantial premia for the diffusive mark-to-market risk that is caused by firms' common factor exposure, and the jump-to-default risk in swap values that comes from the impact of an event on the portfolio constituents. Risk premia vary dramatically across time, portfolio composition, and holding period.

Keywords: Correlated default, risk premium, intensity, feedback, contagion.

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