Quotation Friewald, Nils. 2009. Estimating Asset Correlation from CDS Spreads: An Analysis of the Hedge Effectiveness of FTD Baskets.




Modeling default dependence for measuring and managing portfolio credit risk is one of the most challenging problems in modern finance. The standard industry model is a multi-variate Gaus- sian latent-variable model where the latent variables are associated with log asset value processes. These processes are most commonly modeled by a firm specific and a single market factor with a constant factor loading determining the strength of correlation between the asset values. Estimat- ing asset correlations is not straightforward because asset values are per se not observable. Stan- dard practice suggests estimating asset values from stock prices using the Black-Scholes-Merton framework and computing the correlation parameter from the obtained asset values. However, it is well known that this model is based on several simplifying assumptions and, moreover, relies on infrequently updated accounting data. In this paper we apply a latent variable model to estimate the log asset returns from observable CDS spreads. In a market without reliable prices, such as for first-to-default (FTD) baskets, we compare our model with the standard industry model by ana- lyzing the hedge effectiveness on FTD baskets for three different regimes: the GM/Ford crisis, the sub-prime crisis and the period in between, when market conditions were more normal. We find both models to perform similarly but in periods of severe market turbulences such as the ongoing sub-prime crisis the spread model is more favorable, since it results in hedging error distributions with substantially lower dispersion.


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Publication's profile

Status of publication Published
Affiliation WU
Type of publication Working/discussion paper, preprint
Language English
Title Estimating Asset Correlation from CDS Spreads: An Analysis of the Hedge Effectiveness of FTD Baskets
Year 2009
URL http://ssrn.com/abstract=1456387


Friewald, Nils (Former researcher)
Institute for Banking and Finance IN (Former organization)
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