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Correlated default with incomplete information

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  • Giesecke, Kay

Abstract

We propose a model of correlated multi-firm default with incomplete information. While public bond investors observe issuers' assets and defaults, we suppose that they are not informed about the threshold asset level at which a firm is liquidated. Bond investors form instead a prior on these thresholds. Stochastic dependence between default events is induced through correlated asset values and correlated default thresholds. The former results from dependence of firms on common macroeconomic factors, while the latter corresponds to direct inter-firm linkages. Having addressed this issuer interdependence, the predictions of our model are consistent with empirically well documented facts, in particular the clustering of defaults. We characterize joint conditional default probabilities as assessed by the imperfectly informed secondary market. The representation of dependence via (conditional) copulas is emphasized. We propose the default time copula as a consistent default correlation measure, which overcomes the limitations of existing covariance based measures. A case study is examined, where issuers' assets follow geometric Brownian motions and bond investors' threshold prior is uniform.

Suggested Citation

  • Giesecke, Kay, 2001. "Correlated default with incomplete information," SFB 373 Discussion Papers 2002,30, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    • Handle: RePEc:zbw:sfb373:200230
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    References listed on IDEAS

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    1. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-664, May.
    2. Robert A. Jarrow & David Lando & Fan Yu, 2008. "Default Risk And Diversification: Theory And Empirical Implications," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 19, pages 455-480, World Scientific Publishing Co. Pte. Ltd..
    3. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
    4. Giesecke, Kay, 2001. "Default compensator, incomplete information, and the term structure of credit spreads," SFB 373 Discussion Papers 2002,8, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    5. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515, World Scientific Publishing Co. Pte. Ltd..
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    Cited by:

    1. Chae Woo Nam & Tong Suk Kim & Nam Jung Park & Hoe Kyung Lee, 2008. "Bankruptcy prediction using a discrete-time duration model incorporating temporal and macroeconomic dependencies," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 27(6), pages 493-506.
    2. Stuart Turnbull & Jun Yang, 2008. "Default Dependence: The Equity Default Relationship," Staff Working Papers 08-1, Bank of Canada.
    3. Balakrishna, B S, 2006. "A Semi-Analytical Parametric Model for Dependent Defaults," MPRA Paper 14918, University Library of Munich, Germany, revised 15 May 2007.
    4. Yu, Fan, 2005. "Accounting transparency and the term structure of credit spreads," Journal of Financial Economics, Elsevier, vol. 75(1), pages 53-84, January.
    5. Giesecke, Kay & Weber, Stefan, 2002. "Credit contagion and aggregate losses," SFB 373 Discussion Papers 2002,73, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    6. Balakrishna, B S, 2007. "Delayed Default Dependency and Default Contagion," MPRA Paper 14921, University Library of Munich, Germany, revised 15 May 2007.
    7. Sanjiv R. Das & Rangarajan K. Sundaram, 2007. "An Integrated Model for Hybrid Securities," Management Science, INFORMS, vol. 53(9), pages 1439-1451, September.

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    More about this item

    Keywords

    incomplete information; correlated defaults; default clustering; joint default distribution; copulas;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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