Wednesday, September 1, 2010  Why default correlation matters
(Part 1)  In this post, I will focus on the underappreciated
topic of default correlation, how it might be related to equity
correlation, and what it means for the VaR of your corporate
credit portfolio. Balanced fund managers take note!  To begin,
let's establish some terminology. Consider obligors A and B, and
a time horizon T. Let's denote the probability of default of A
before T by pA and similarly the probability of default of B
before T by pB.  Now for a little pop quiz.  Question: With
knowledge of pA and pB you can determine which of the following?
1. PA|B The conditional probability that A defaults given B has
defaulted   2. PAB The joint probability that both A and B
default   3. rAB The linear correlation coefficient between the
default indicator events IA and IB   4. None of the above
Unfortunately, knowledge of the marginal probabilities of
default is insufficient to determine the conditional
probabilities of default, the joint proba