1

Schwarz Robert
University of Applied Sciences BFI Vienna

Default Correlation: An empirical approach

Introduction

The default probability (PD) and default correlation are the key drivers for credit
risk in a bank loan portfolio. While there exist many models for estimating the
default probability there is still a lot of research to do for estimating the default
correlation. The default correlation is a measure for the sensitivity of the PD to
the systematic risk factor which represents the state of the economy. If two
companies have a strong dependency on the same systematic risk factors then
they have a higher default correlation. In the one-factor risk model the
correlation is a measure for the joint dependency of companies on one
systematic risk factor The joint default probability is the probability that two
companies default at the same time horizon.

The new Basel Accord (Basel II) assumes that the correlation of a company with
turnover between € 5 and € 50 million increases exponential to the size of the
firm and that the default correlation decline with the PD. In this paper the
correlation of 110.000 Austrian small and medium-sized enterprises (SME) will
be estimated empirical with time series of defaults. The non-parametric probit
ordered model by Gordy is used for the calculation of the asset correlation [3].
After estimating the asset correlation it is possible to calculate the default
correlation analytically.

1) The one-factor risk model

The one-factor risk model uses the computation of the asset correlation due to
the works of Merton [4]. In these models a default event occurs if the firm value
of obligor i crosses the default threshold. In our probit ordered model the default
event is driven by a latent variable U i which is a function of a systematic factor
F and a firm specific (idiosyncratic) factor ε i
U i = ρ ⋅ F + (1 − ρ ) ⋅ ε i (1)
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where F and ε i are uncorrelated standard normal distributed variables. In this

case the latent variable U i is also a standard normal distributed variable and the
borrower defaults when the latent variable falls below a certain threshold:

ρ ⋅ F + (1 − ρ ) ⋅ ε < Φ PD
i
−1
( ) (2)

where Φ −1 (.) is the inverse standard normal CDF and PD is the unconditional
(long term) PD for a given rating. The weighting ρ is a measure of the
sensitivity of the borrower to the systematic factor. If the realisation of the
systematic factor is low the conditional PD is relatively low and vice versa. It is
obvious that a strong sensitivity to the systematic factor implicates a higher
correlation of the borrowers and a higher volatility of the default rates.

Cor [U i ,U j ] = ρ (3)

It is possible to calculate the PD conditional on the realization of the systematic

factor from equation (2):

 −1 
 Φ ( PD ) − ρ ⋅ f 
PD ( f ) = Φ (4)
 1− ρ 
 

Assuming that the conditional defaults are independent the variance of the
jointly default of two obligors with the same unconditional probability of default
PD is

[ ( ) ( ) ]
Var [PD ( f )] = BIVNOR Φ −1 PD , Φ −1 PD , ρ − PD
2
(5)

with BIVNOR as the bivariate normal distribution. The variance of the

conditional PD is calculated with the method from Gordy. The next step is to
calculate the asset correlation ρ iteratively.
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2) Data from an Austrian information provider

We used the data from Austrian rating agency and information provider KSV1
for the calculation of the default probability. The data sample includes around
110.000 Austrian small and medium sized companies separated in industry-
codes and rating classes. The following figure shows the rating class distribution
of Austrian firms separated in three size classes (annual turnover). The ratings
range from 100 (lowest credit risk) to 699 (highest credit risk).

Figure 1: Rating class distribution of Austrian Firms 2003

60,00%

50,00%

40,00%
to 1M€
30,00% 1-5M€

20,00% 5-50M€

10,00%

0,00%
100-199 200-299 300-399 400-499 500-599 600-699
Rating classes

Source: KSV

Almost 90% of the firms are in the rating classes 200-299 (small risk) and 300-
399 (medium risk). Analysis show that on average larger SMEs (turnover
between 5 and 50M€) have a better rating than smaller companies. The table 1
shows the annual default probabilities in Austria over the 2000-2003 periods:

1
Homepage: www.ksv.at
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Table 1: Annual default probabilities in Austria

Rating classes -1M€ 1-5 M € 5-50 M €
1 0,22 0,0 0,25
2 0,37 0,38 0,22
3 1,24 2,01 0,88
4 6,33 7,7 5,36
5 14,66 23,47 17,4
6 26,72 27,66 33,33
Total 1,55 1,77 0,77
Source: KSV

3) Empirical Results

At first the default probability (PD) in all panels has to be calculated which is an
weighted average of the default time series from 2000 - 2003 and rating
migrations during the year are neglected. Now it is possible to calculate the asset
correlation with the non-parametric method from Gordy using the average PD,
the variances of the default time series and the number of companies in each
class.

Table 2: Asset correlation in %

Rating classes -1M€ 1-5 M € 5- 50 M € Total
1 0 0 n.a. 0
2 0,39 1,31 n.a. 0,70
3 0,92 1,89 2,0 1,04
4 1,30 2,35 3,97 1,19
5 2,14 6,01 n.a. 2,54
6 6,5 5,56 n.a. 4,69
Total 0,59 1,98 1,33 0,82
Source: Own study

The results show that the companies with more than 1 M€ turnover have on
average a higher asset correlation than smaller companies. One possible reason
for this is that larger companies have a higher share in cyclical industries that
means that they have a higher dependency from the systematic risk factor. An
other possible reason is the higher diversification of large companies which
reduces the idiosyncratic risk. This result confirms the assumption of the IRB-
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approach in Basel II which supposes a negative correlation between asset

correlation and firm size.

An analysis of the asset correlation with respect to the rating classes shows a
positive correlation between individual PD and asset correlation. This is an
indication that companies in worse rating classes are more affected by an
economic downturn – which implies a higher dependency on the systematic risk
factor – than companies with lower PD.

The correlation estimations have a maximum of 6,5% which is very low2. One
reason might be that the used time series (4 years) do not cover the whole
business cycle and therefore the variance of the default time series can be
relatively low. The second reason is that the data include around one third of all
Austrian companies which reduces the correlation because of the high
diversification effect. The bootstrap methodology was used for calculating the
correlation in a portfolio with 5000 small companies with turnover less than 1
million € , in a portfolio with 2000 medium-sized companies with turnover
between 1 and 5 million € and in a portfolio with 1000 companies with turnover
between 5 and 50 million €. With bootstrapping it is possible to calculate the
mean, standard deviation and confidence interval for each simulated portfolio.

Table3: Asset correlations in % with bootstrapping

Size class Mean Standard 95% Confi- 99% Confi-
deviation denz interval denz interval

Small SME 1,83 0,91 0,46 – 4,14 0,18 – 4,9

(5000 exposures)
Medium SME 2,59 0,94 0,64 – 4,42 0,03 – 4,94
(2000 exposures)
Large SME 2,16 1,6 0,15 – 6,46 0,00 – 7,39
(1000 exposures)

Total 1,6 0,38 0,94 – 2,46 0,92 – 2,67

Source : Own study

An analysis of table 3 shows that the mean value of the asset correlations
in all three portfolios is higher than the estimated values in table 2
because of the reduced diversification effect. An other result is that the
standard deviation of the estimated correlation is negative correlated with
2
[1] and [5] get similar results
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the number of companies in a portfolio which confirms the IRB-formula where

ceteris paribus a higher asset correlation for larger companies is supposed.

4) Default correlation

It is possible to calculate the default correlation analytically given the asset

correlation. In the case of two obligors A and B the default correlation is given
by the definition of the linear correlation coefficient [6, p. 292]:

PD AB − PD A ⋅ PDB
Q AB = (6)
PD A ⋅ (1 − PD A ) PDB ⋅ (1 − PDB )
with
Q AB default correlation
PD AB joint default probability
PD A , PDB individual unconditional PD

The joint default probability is the probability that both obligors default at a
fixed time horizon that means their assets fall below a certain threshold.
Therefore the jointly default of two obligors with the same unconditional PD is:3

[ ( )
PD AB = BIVNOR Φ −1 PD , Φ −1 PD , ρ ( ) ] (7)

The unconditional PD and the asset correlation ρ are known. Finally the default
correlation can be calculated (equation 6). Figure 2 shows the default correlation
as a strict monotonous increasing function of the asset correlation with different
unconditional PD.

3
See part 1: One-factor risk model
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Figure 2: Default correlation as a function of asset correlation

0,25
PD = 0,5%
default correlation

0,20
PD = 1%
0,15 PD = 2%
0,10 PD = 3%
PD = 4%
0,05
PD = 5%
0,00
0 0,1 0,2 0,3 0,4 0,5
asset correlation

Source: Own study

Table 4 shows the default correlations with respect to the asset correlations in
table 2. It is obvious that the default correlations approximate the asset
correlation for higher PD (rating classes 5 and 6).

Table 4: Default correlation in %

Rating classes -1M€ 1-5 M € 5- 50 M € Total
1 0 0 n.a. 0
2 0,01 0,04 n.a. 0,02
3 0,07 0,19 0,17 0,09
4 0,29 0,62 1,09 0,28
5 0,79 2,8 n.a. 0,98
6 3,09 2,99 n.a. 2,34
Total 0,05 0,18 0,09 0,07

Source: Own study

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Conclusion

In this paper we estimated the default correlation of Austrian SMEs with an

empirical approach. Default correlation is a key driver for credit risk. Results
show a positive correlation between default correlation and individual
probability of default which is not assumed in Basel II. The asset correlation
estimations have a maximum of 6,5% which is very low compared to Basel
formulas which assume a correlation between 12% and 24%. The results could
be affected by the length of time series of default (in our case only four years)
and by the definition of default. In the future there is still a lot of research to do
for estimating the default correlation.

Bibliography

1. BIS, International Convergence of Capital Measurement and Capital

Standards, June 2004
1. Dietsch M., Petey J., Should SME exposures be treated as retail or
corporate exposures? A comparative analysis of default probabilities and asset
correlations in French and German SMEs, “Journal of Banking & Finance”,
April 2004, volume 28, issue 4
2. Gersbach H., Lipponer A., The correlation effect, Working Paper,
University of Heidelberg, 2000
3. Gordy M.B., A Comparative Anatomy of Credit Risk Models, “Journal of
Banking & Finance”, January 2000, volume 24, issues 1-2
4. Merton, R., On the Pricing of Corporate Debt: The Risk Structur of
Interest Rates, “The Journal of Finance”, 1974, volume 29
5. Rösch D., Correlations and Business Cycles of Credit Risk: Evidence from
Bankruptcies in Germany, “Financial Markets and Portfolio Management”,
2003, volume 17, issue 3
6. Schönbucher P.J., Credit derivatives pricing models, John Wiley & Sons,
UK, 2003
7. Servigny A., Renault O., Default correlation: empirical evidence,
Working Paper, Standard & Poors, 2002
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Summary

The paper estimates the joint default probabilities of SMEs in Austria with an
one-factor risk model. The joint default probability is the probability that
companies default at the same time. The asset-value of a company is a function
of systematic risk-factors (macro-variables) and an unsystematic risk-factor
(company specific risks). The asset-correlation in the one-factor risk model is a
measure of the joint dependency of companies on one systematic risk-factor
which is also assumed in the IRB-approach in Basel II. The asset correlation is
estimated from time series with defaults of 110.000 Austrian companies with a
probit ordered model (Gordy, 2000). The sample is divided into categories that
are homogenous with respect to rating-class, industry and firm size. The joint
default probability has been calculated as a function of the asset correlation and
time series with defaults in every category. Results show that the joint default
probability increases on average with the individual default probability which is
not assumed by Basel II. SMEs with an annual turnover up to 1 million € have
the weakest joint default probability and SMEs with a turnover between 1 and 5
million € have the highest correlation.