The Empirical Relation between CreditQuality, Recovery, and Correlation

Credit risk is an important issue in many nance areas, such as the determinationof cost of capital, the valuation of corporate bonds and pricing of credit derivatives.Credit risk has also been a cause and consequence of the current nancial crisis.Thus, methods for measuring credit risk, default probabilities, and recoveries havecaught more and more attention in the nancial literature.The majority of industry credit portfolio risk models, as well as recent scienticresults, are based on isolated modules for default probabilities and recoveries inthe event of default. This paper shows that these common methods lead to variouseconometric drawbacks when the parameters are interpreted and aggregated for riskcapital allocation and pricing purposes.[...]