Asset Correlations A Literature Review and Analysis of the Impact of Dependent Loss Given D.pdfVIP

Asset Correlations: A Literature Review and Analysis of the Impact of Dependent Loss Given Defaults Andrew Chernih ∗† Steven Vanduffel ‡ Luc Henrard § November 6, 2006 Abstract The Basel II Accord outlines a general framework for determining regula- tory capital requirements for credit risk portfolios. Different obligors usually operate in dependent socio-economic environments and these structural cor- relations are the main reason why regulatory capital is needed. Therefore, it is not surprising that an important component of the regulatory regime for capital is the asset correlation between obligors. Basel II has set a range for corporate asset correlations from 8 to 24%, the exact value depending on several individual firm characteristics. We use monthly asset value data to calculate asset correlations and compare these with Basel II as well as results from other papers. Our results are in line with literature but a clear difference is found between the majority of these results and the results from Basel II and some major software providers. We discuss these differences and offer some explanations as an attempt to recon- cile the differences: we argue that assuming independent loss given defaults ∗Corresponding author. Address: 9 Marcia St, Toongabbie NSW 2146, Australia. Fax: +61 2 9631 6641. E-mail: andrew@ †The authors would like to thank Alan Pitts and Karl Rappl at UBS and Mark Lundin, Stephanie Authier, Ivan Goethals and Bruno de Cleen at Fortis Bank and Wim Schoutens at KUL for helpful discussions. ‡Katholieke Universiteit Leuven and Universiteit van Amsterdam. E-mail: steven.vanduffel@econ.kuleuven.ac.be §Chief Risk Officer, Fortis Bank and Universite Catholique de Louvain. E-mail: luc.henrard@ 1 can and should affect