On Default Correlation: A Copula Function Approach (2000, pdf) Sep 04 2019 16:14 languageMoneyScience
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David X. Li
This paper studies the problem of default correlation. We first introduce a random variable called “time-until-default” to denote the survival time of each defaultable entity or financial instrument, and define the default correlation between two credit risks as the correlation coefficient between their survival times. Then we argue why a copula function approach should be used to specify the joint distribution of survival times after marginal distributions of survival times are derived from market information, such as risky bond prices or asset swap spreads. The definition and some basic properties of copula functions are given. We show that the current CreditMetrics approach to default correlation through asset correlation is equivalent to using a normal copula function. Finally, we give some numerical examples to illustrate the use of copula functions in the valuation of some credit derivatives, such as credit default swaps and first-to-default contracts.
This paper became famous for many of the wrong reasons, and engenders strong reactions, both from Li's supporters and those who later came to aportion blame for the financial crisis, Famously, Felix Salmon wrote about Li and his work in his controversial article for Wired: Recipe for Disaster: The Formula That Killed Wall Street.
The Paper has been cited more than 1000 times according to Google Scholar.