What is the relevance of correlations from a credit portfolio risk management perspective?
Correlation is a powerful statistical tool that has been widely applied in domains such as science, sociology, economics, and finance. It is well known for its applications in numerous domains of finance including equities, derivatives, currencies, and interest rates. It can also be used to analyze credit portfolios. It is, however, still evolving. Correlation is an important factor in credit portfolio risk management, as acknowledged by Basel II and III.
The correlation value ranges from +1 (perfect positive correlation) to –1 (perfect negative correlation), with 0 indicating no association. Perfect correlation indicates that both variables are going in the same direction and may be influenced by the same underlying sources or causes. Negative correlations indicate that both variables react in the opposite direction to external stimuli.
Returning to the importance of correlation in credit portfolio risk management, historical research demonstrates that there is a correlation in credit risk that changes across business cycles and enterprises. During economic downturns, the credit risk connection also rises. As a result, from the standpoint of systematic risk, it is acceptable to assume that overall credit risk is positively connected with economic downturns. This knowledge should be valuable when creating a credit portfolio. Non-cyclical sectors have a weaker link to economic downturns because they are less affected by them. Construction, the financial industry, and real estate, on the other hand, have a comparatively stronger correlation, indicating that economic upheaval has a greater impact on these industries. Correlation studies can be divided into different categories as needed; for example, sector-specific correlation and default correlation are shown below:
- Sector correlation: When all else is equal (i.e., sufficient obligor credit risk), sectors with negative correlation are the best option for building a credit portfolio. (See also the Diversification chapter.)
- Default correlation: When the credit risk of the obligor is considerable, sector correlation becomes meaningless. The risk of default increases when obligor credit risk deteriorates, regardless of sector diversity. As a result, the default correlation increases as the credit rating approaches worse quality. This demonstrates the significance of obligor credit risk analysis, which we explored extensively in previous portions of the book.