Inferring Default Correlation from Equity Return Correlation

Abstract

This paper presents a new approach for estimating default correlation by linking default correlation to equity return correlation while preserving the fundamental relation between default and asset correlations in the structural framework. Our hybrid model thus overcomes a long-standing empirical difficulty that default correlation estimation relies on the unobservable asset process. The empirical analysis shows that our hybrid model demonstrates a considerable improvement over the existing structural model of Zhou (2001) for the sample periods of 1970-1993 and 1990-2010. We also illustrate the difference between the two models in predicting default correlations over the period of the 2008 financial crisis.