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Inferring Correlations of Asset Values and Distances-to-Default from CDS Spreads: A Structural Model Approach

Author

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  • Chanatip Kitwiwattanachai
  • Neil D. Pearson

Abstract

Using structural credit risk models to estimate default dependence requires estimates of correlations of changes in distance-to-default. We present a structural model that yields simple relations between asset value, distance-to-default, and CDS spreads, allowing the correlations to be estimated from CDS spreads. We generalize the model to include a randomly varying default boundary; in this version the distance-to-default dynamics also depend on the movement of the default boundary. The CDS spread correlations we estimate exceed equity correlations, consistent with a randomly varying default boundary. We also present evidence that variations in funding liquidity affect the correlations, consistent with recent models.

Suggested Citation

  • Chanatip Kitwiwattanachai & Neil D. Pearson, 2015. "Inferring Correlations of Asset Values and Distances-to-Default from CDS Spreads: A Structural Model Approach," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 5(1), pages 112-154.
    • Handle: RePEc:oup:rasset:v:5:y:2015:i:1:p:112-154.
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    File URL: http://hdl.handle.net/10.1093/rapstu/rav001
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    Cited by:

    1. Choi, Yong Seok & Doshi, Hitesh & Jacobs, Kris & Turnbull, Stuart M., 2020. "Pricing structured products with economic covariates," Journal of Financial Economics, Elsevier, vol. 135(3), pages 754-773.

    More about this item

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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