THE ROLE OF DEFAULT CORRELATION IN VALUING CREDIT DEPENDANT SECURITIES

In this thesis, I imply a forward-looking systematic factor from CDO market spreads; I show that this factor is a measure of CDO market’s expectation of future default correlation, and I empirically show that it is positively related to bond credit spreads. From this, I infer that corporate bond credit spreads are positively related to expected default correlation. The forward-looking factor stems from a CDO valuation model that I propose. The model assumes default can be characterized as a random event that occurs with an uncertain hazard rate that is mixture-Weibull distributed. Calibrating the model to CDO market spreads implies the model parameters. Using two and three mixing densities and data spanning January 2004 to February 2008, I show that the model calibrates to both the North American and European investment grade CDOs with negligible error. The factor I imply from the CDO market quotes is the standard deviation of the implied hazard rate density. I then show that the standard deviation of the implied hazard rate density increases as default cor-relation increases. This is done by characterizing firms ’ defaults with stochastic hazard rates that are defined by jump-diffusion processes that are correlated only through the Weiner processes, only through systematic jumps, or both. I use the models to generate CDO model spreads that are used to impl