Correlations in firm default behavior

Abstract

Modeling credit risk using Structural and Reduced Form models has been a popular and apropos topic of research. This work makes an attempt to better understand correlations in firm default. A review of contemporary research reveals several models with varying degrees of assumptions around firm default and how they relate to macroeconomic variables. More recent literature also makes use of a doubly stochastic assumption which in essence holds that given a certain path of covariates the default probabilities of two similar firms is independent. We explore empirical evidence which points to correlated defaults conditional on various explanatory covariates. Given the strong similarities in underlying firm structure and relationship to macro-economic environment, it can be hypothesized that there exist correlations in default behavior among similar firms.