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Asset correlation estimation for inhomogeneous exposure pools

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  • Christoph Wunderer

Abstract

A possible data source for the estimation of asset correlations is default time series. This study investigates the systematic error that is made if the exposure pool underlying a default time series is assumed to be homogeneous when in reality it is not. We find that the asset correlation will always be underestimated if homogeneity with respect to the probability of default (PD) is wrongly assumed, and the error is the larger the more spread out the PD is within the exposure pool. If the exposure pool is inhomogeneous with respect to the asset correlation itself then the error may be going in both directions, but for most PD- and asset correlation ranges relevant in practice the asset correlation is systematically underestimated. Both effects stack up and the error tends to become even larger if in addition a negative correlation between asset correlation and PD is assumed, which is plausible in many circumstances and consistent with the Basel RWA formula. It is argued that the generic inhomogeneity effect described is one of the reasons why asset correlations measured from default data tend to be lower than asset correlations derived from asset value data.

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  • Christoph Wunderer, 2017. "Asset correlation estimation for inhomogeneous exposure pools," Papers 1701.02028, arXiv.org, revised Sep 2019.
    • Handle: RePEc:arx:papers:1701.02028
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    References listed on IDEAS

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    1. Michel Dietsch, 2004. "Should SME exposures be treated as retail or corporate exposures: a comparative analysis of probabilities of default and assets correlations in French and German SMEs," ULB Institutional Repository 2013/14164, ULB -- Universite Libre de Bruxelles.
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    7. Dietsch, Michel & Petey, Joel, 2004. "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, Elsevier, vol. 28(4), pages 773-788, April.
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    Cited by:

    1. Henry Penikas, 2020. "IRB Asset and Default Correlation: Rationale for the Macroprudential Add-ons to the Risk-Weights," Bank of Russia Working Paper Series wps56, Bank of Russia.
    2. Henry Penikas, 2023. "IRB Asset and Default Correlation: Rationale for the Macroprudential Mark-Ups to the IRB Risk-Weights," Risk Management, Palgrave Macmillan, vol. 25(1), pages 1-27, March.

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