Hypothesis Test of Default Correlation and Application to Specific Risk

Credit migration correlation is a critical assumption for the integration of market risk and credit risk within enterprise‐wide risk management. This article describes hypothesis testing performed on credit migration correlation, based on two models: 1) a factor model and 2) an asset‐value model. These tests involve both the correlation between obligors and the correlation between credit migration events and systematic market risk factors. The author concludes from the test results that over shorter risk horizons (e.g., biweekly or monthly) where all relevant underlying processes are distributed multi‐variate normal, non‐zero positive correlation weights overestimate risk capital requirements, on average.