Estimating asset correlations fromstock prices or default rates –which method is superior?

This paper sets out to help explain why estimates of asset correlations based on equityprices tend to be considerably higher than estimates based on default rates. Resolving thisempirical puzzle is highly important because, rstly, asset correlations are a key driver ofcredit risk and, secondly, both data sources are widely used to calibrate risk models ofnancial institutions. By means of a simulation study, we explore the hypothesis that differencesin the correlation estimates are due to a substantial downward bias characteristicof estimates based on default rates. Our results suggest that correlation estimates fromequity returns are more ecient than those from default rates. This nding still holdsif the model is misspecied such that asset correlations follow a Vasicek process whichaects foremost the estimates from equity returns. The results lend support for the hypothesisthat the downward bias of default-rate based estimates is an important althoughnot the only factor to explain the dierences in correlation estimates. Furthermore, ourresults help to quantify the estimation error of asset correlations dependent on the riskcharacteristics of the underlying data base...