The asset correlation analysis in the context of economic cycle
Probability of default represents an idiosyncratic element of bank risk profile and accounts for an inability of individual debtor to repay its credit obligation. Idiosyncratic risk however does not address any interaction or dependencies streaming from external economic environment, nor the correlation between individual obligors. Credit risk quantification framework accounts for a systematic element of the risk using a concept of asset correlations and joined probability of default. In this paper we focus on the evolution of asset correlations in time and its dependence on economic cycle while asset correlations are proxied by the pairwise stock returns correlations of publicly traded companies. Our analysis proves that a systematic risk is significantly higher in the period of economic downturn where correlations between obligors more than doubled. The analysis also provides a view of systematic risk and its sensitivity to economic cycle between various regions and economic sectors. These observations can be used by banking institutions in the bank risk management and stress testing framework setup.
Key word: Economic capital, asset correlations, systematic credit risk
JEL classification: G32, G21