Asset Correlations: A Literature Review and Analysis of the Impact of Dependent Loss Given Defaults

by Andrew Chernih of the University of New South Wales,
Steven Vanduffel of Katholieke Universiteit Leuven & Universiteit van Amsterdam, and
Luc Henrard of Fortis Bank & Universite Catholique de Louvain

November 6, 2006

Abstract: The Basel II Accord outlines a general framework for determining regulatory capital requirements for credit risk portfolios. Different obligors usually operate in dependent socio-economic environments and these structural correlations are the main reason why regulatory capital is needed. Therefore, it is not surprising that an important component of the regulatory regime for capital is the asset correlation between obligors. Basel II has set a range for corporate asset correlations from 8 to 24%, the exact value depending on several individual firm characteristics.

We use monthly asset value data to calculate asset correlations and compare these with Basel II as well as results from other papers. Our results are in line with literature but a clear difference is found between the majority of these results and the results from Basel II and some major software providers. We discuss these differences and offer some explanations as an attempt to reconcile the differences: we argue that assuming independent loss given defaults can and should affect the asset correlations used. The impact of horizon is considered as well.

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