Inferring Default Correlation from Equity Return Correlation

This paper presents a new approach for estimating default correlation among firms. This approach overcomes an empirical difficulty encountered in estimating default correlation from the unobservable asset process using the structural model. The unique feature of this approach is that it directly links default correlation to equity return correlation while preserving the fundamental relation between default and asset return correlations and the linkage among key financial decision variables in the structural model. Empirical results show that our (hybrid) model outperforms other models in predicting default correlation. Results indicate that a careful specification of the structural model can significantly improve the model performance. Our finding suggests that structural models are a very useful tool for extracting default correlation