The determinants of default correlations

Abstract

This chapter analyses the ability of some structural models to predict corporate bankruptcy. The study extends the existing empirical work on default risk in two ways. First, it estimates the expected default probabilities (EDPs) for a sample of bankrupt companies in the USA as a function of volatility, debt ratio, and other company variables. Second, it computes default correlations using a copula function and extracts common or latent factors that drive companies’ default correlations using a factor-analytical technique. Idiosyncratic risk is observed to change significantly prior to bankruptcy and its impact on EDPs is found to be more important than that of total volatility. Information-related tests corroborate the results of prediction-orientated tests reported by other studies in the literature; however, only a weak explanatory power is found in the widely used market-to-book assets and book-to-market equity ratio. The results indicate that common factors, which capture the overall state of the economy, explain default correlations quite well.