Correlation in Corporate Defaults: Contagion or Conditional Independence?

Abstract

We revisit a test for conditional independence in intensity models of default proposed by Das, Duffie, Kapadia, Saita (2007) (DDKS). Based on a sample of US corporate defaults, they reject the conditional independence assumption but also observe that the test is a joint test of the specification of the default intensity of individual firms and the assumption of conditional independence. We show that using a different specification of the default intensity, and using the same test as DDKS, we cannot reject the assumption of conditional independence for default histories recorded by Moody's in the period from 1982 to 2006. We also show, that the test proposed by DDKS is not able to detect all violations of conditional independence. Specifically, the tests will not capture contagion effects which are spread through the explanatory variables ('covariates') used as conditioning variables in the Cox regression and which determine the default intensities of individual firms. We therefore perform different tests to see if firm-specific variables, i.e quick ratios and distance-to-default, are affected by defaults. We find no influence from defaults on Quick ratios, but some influence on distance-to-default. This suggests, that violations of conditional independence do indeed arise from balance sheet effects.