Incorporating exchange rate risk into PDs and asset correlations

Details Incorporating exchange rate risk into PDs and asset correlations Incorporating exchange rate risk into PDs and asset correlations

2007-12-20

arxiv.org/abs/0712.3363v1

Economy

Quantitative Finance

Risk Management

7 pages, 1 figure

Scientific paper

Intuitively, the default risk of a single borrower is higher when her or his assets and debt are denominated in different currencies. Additionally, the default dependence of borrowers with assets and debt in different currencies should be stronger than in the one-currency case. By combining well-known models by Merton (1974), Garman and Kohlhagen (1983), and Vasicek (2002) we develop simple representations of PDs and asset correlations that take into account exchange rate risk. From these results, consistency conditions can be derived that link the changes in PD and asset correlation and do not require knowledge of hard-to-estimate parameters like asset value volatility.

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