Asset Correlation and Credit Quality : The Basel Assumption

The relation between asset correlation and default probability is critical for determining bank regulatory capital requirements. It is assumed negative for sovereign, corporate and banking exposures by the Basel Committee on Banking Supervision. This article provides likelihood ratio tests for the relation. To develop them, we extend the estimation procedure of Jones and Zanganeh (2011) to a multi-factor structure. This permits parsimonious modeling of comovements between financial assets, and serves a variety of applications in risk management and asset allocation. Using monthly stock prices 2002-2011 of North American companies, we find that asset correlation tends to increase as credit quality (measured by agency ratings) decreases. The exact pattern varies across industries and over time. We also observe systematic impact of the financial crisis on stock price dynamics: volatility and correlation increase substantially from the second quarter of 2008 and decline toward the end of sample period