From equity to default correlation with taxes

Sheen Liu, Howard Qi, Yan Alice Xie

Research output: Contribution to journalArticlepeer-review


For fixed income investment, the preponderant risk is the clustering of defaults in the portfolio. Accurate prediction of such clustering depends on the knowledge of default correlation. We develop models with exogenous debt and endogenous debt to predict default correlations from equity correlations based on a self-consistent structural framework. We also examine how taxes affect the prediction of default correlations based on the two models. The empirical analysis shows that the corporate taxes tend to decrease default correlations, while personal taxes could increase or decrease default correlations. Our default correlation model with exogenous debt does a better job of predicting default correlations for high quality bonds, while the one with endogenous debt predicts more accurately for lower rated bonds. Our studies not only theoretically improve the modeling of default correlation in the structural setting but also shed new light on various aspects of default correlations and thereby help financial practitioners price credit derivatives more accurately and formulate more effective strategies to manage default risk of credit portfolios.

Original languageEnglish (US)
Pages (from-to)1373-1388
Number of pages16
JournalQuantitative Finance
Issue number8
StatePublished - Aug 2 2020
Externally publishedYes


  • Default correlation
  • Equity correlation
  • Structural model
  • Taxes

ASJC Scopus subject areas

  • General Economics, Econometrics and Finance
  • Finance


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