Dynamic Diversification in Corporate Credit

Author:

Peter Christoffersen   Kris Jacobs   Xisong Jin  

Issue Date:

2013

Abstract(summary):

This paper documents cross-sectional dependence in CDS spreads, and compares it with de- pendence in equity returns. Our results are largely complementary to existing correlation and dependence estimates, which are typically based on historical default rates or factor models of equity returns, and to existing intensity-based studies, which characterize observable macro variables that induce realistic correlation patterns in default probabilities (see Duffee (1999) and Duffie, Saita and Wang (2007)). Importantly, we use econometric techniques that allow us to estimate a model with multivariate asymmetries and time-varying dependence using a long time series and a large cross-section of CDS spreads. We document six important stylized facts. First, copula correlations in CDS spreads vary substantially over our sample, with a significant increase following the financial crisis in 2007. Equity correlations also increase in the financial crisis, but somewhat later, and the increase is less significant and not as persistent. Second, our estimates indicate fat tails in the univariate distributions, but also multivariate non-normalities. Multivariate asymmetries seem to be less important for credit than they are for equities. Third, credit dependence is more persistent than equity persistence, and this greatly affects how major events such as the Quant Meltdown, the Lehman bankruptcy, and the U. S. sovereign debt downgrade affect subsequent dependence in credit and equity markets. Fourth, tail dependence increases more significantly over the sample than copula correlations. Fifth, economic variables explain a significant part of the time-series variation in dependence and tail dependence. Sixth, the dependence and tail dependence measures are related to the time-series variation in credit spreads, even after accounting for other well-known firm-level determinants of spreads. These stylized facts, and the increase in cross-sectional dependence in particular, have important implications for the management of portfolio credit risk. We illustrate these impli- cations by computing the diversification benefits from selling credit protection. The increase in cross-sectional dependence following the financial crisis has reduced diversification benefits, not unlike what happened in equity markets. When computing diversification benefits, taking non-normalities into account is more important for credit than for equity. Several other important implications of our results deserve further study. First, given the richness and complexity of the equity and credit dependence, it may prove interesting to explore the implications for the pricing of structured products. In particular it would be interesting to investigate if the CDO pricing model suggested by the estimated dynamics removes some of the observed correlation smile in CDO tranches. See Berd, Engle, and Voronov (2007) for an example of such an approach. Second, our estimates can be used to manage a portfolio of counterparty risks. Third, our approach can be used to integrate credit and equity dependence dynamics in a single portfolio exercise that allows for diversification across asset classes. Finally, a possible extension is to investigate alternative measures of credit portfolio risk (Vasicek 1987, 1991, 2002).

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