The pricing of correlated default risk:evidence from the credit derivatives market

In order to analyze the pricing of portfolio credit risk – as revealed by tranche spreadsof a popular credit default swap (CDS) index – we extract risk-neutral probabilities ofdefault (PDs) and physical asset return correlations from single-name CDS spreads. Thetime profile and overall level of index spreads validate our PD measures. At the sametime, the physical asset return correlations are too low to account for the spreads of indextranches and, thus, point to a large correlation risk premium. This premium, which covariesnegatively with current realized correlations and positively with future realizedcorrelations, sheds light on market perceptions of and attitude towards correlation risk...