Default Probabilities and Default Correlations

Economics
Quantitative Analysis
December 3, 2001
Research Notes
in Economics & Statistics
Default Probabilities and Default

Correlations
Starting from the Merton framework for firm defaults, we provide the
analytics and robustness of the relationship between default
probabilities and default correlations. We show that loans with higher
default probabilities will not only have higher variances but also higher
correlations with other loans. As a consequence, portfolio standard
deviation can increase substantially when loan default probabilities rise.
This result has two important implications. First, relative prices of loans
with different default probabilities should reflect the differential impact
on portfolio standard deviation. Second, the standard deviation of loan
portfolios and of default rates, as well as the required economic capital
will vary significantly over the business cycle.
Ulrich Erlenmaier and Hans Gersbach
Editor:
Ann-Charlotte Eliasson
+49 69 910-31832
ann-charlotte.eliasson@db.com
Deutsche Bank Research
Frankfurt am Main
Germany
E-mail: marketing.dbr@db.com
Fax: +49 69 910-31877
Managing Directors
Axel Siedenberg
Norbert Walter

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100
72
80
68
60
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(%)
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64
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40
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60
20
56
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96
97
98
99
100
20
40
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60
80
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#"
30
5.5
Default Correlation (%)
Default Correlation (%)
35
25
20
15
10
5
5
4.5
4
3.5
3
2.5
2
0
20
40
60
80
100
10
Default Probability of both Firms (%)
15
20
25
30
35
40
45
50
Default Probability of Firm 2 (%)
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Default Probabilities and Default Correlations

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Economics

Default Probabilities and Default

Ulrich Erlenmaier and Hans Gersbach

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Default Indicator Firm 2

Default Indicator Firm 1

Default Indicator Firm 1

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Default Correlation (%)

Default Correlation (%)

Default Probability of both Firms (%)

Default Probability of Firm 2 (%)

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Default Point of Firm 2

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