As the world experiences the precarious operating activities of major financial institutions and household company names, the need for comprehensive understanding of default correlation has become increasingly important. By creating various modeling techniques Professor Yue Kuen Kwok at the Hong Kong University of Science and Technology, Mathematics Department and his research team examined the impact of default correlation and related implications.
"Default correlation happens when the collapse of one company or financial institution has a knock on effect and brings down others," said Professor Kwok. Also known as a parent and child relationship, the Professor said a default event could take place in a particular industry sector, as part of a supply chain event or a series of events covering a geographical area, such as Asia experienced during the 1990’s Asian financial crisis.
"Default correlation examines how the likelihood of default changes over time with the infectious effect of a institution or company that owes debt to another individual or company (the creditor), as a result of borrowing or issuing securitised investments," said the Professor. "The analysis explores how the correlated default structures among the protection seller and the reference entity affect the swap rate in credit default swaps," he added.
The dependence of firms on the general economic environment induces dependence between firms' defaults. Another source of default correlation is the borrower-lender or parent-subsidiary structures that provide the direct contagion of financial distress from one firm to another.
"The financial tsunami we are currently experiencing has highlighted the need to investigate and understand default correlation," Professor Kwok said. Understanding default correlation is important for investors and rating agencies such Standards and Poor's (S&P) and Moody's. The understanding of the correlation between default events is also of importance to portfolio management and valuation of credit-sensitive instruments.