Calibration of the Credit Correlation Parameter
Document ID: 2007-193 (previously 2007/018)
Published on: 31st July 2007
Author: Steven Morrison
In the B&H credit model, dependency between credit migrations on individual bond issuers within a particular market is described by a single correlation parameter. This parameter determines the extent to which defaults and migrations are driven off a common market "shock" rather than idiosyncratic, issuer-specific effects and thus affects the amount of diversification that can be achieved by pooling exposure to different issuers into a portfolio.
This note describes the calibration of the credit correlation parameter, motivating the current choice of correlation via a "firm value" interpretation to the dependency model and comparing the default distributions produced with those observed historically. We also look at the pricing of CDOs using our standard correlation assumption and compare with recent market prices.
