"Our work with major financial institutions around the world and with leading hedge funds has shown the critical need to improve on naÃ¯ve approaches to correlated default," said Dr. Donald R. van Deventer, Kamakura chief executive officer. "Major financial institutions seeking compliance with the New Capital Accords from the Basel Committee on Banking Supervision are no longer comfortable assuming all pairs of companies in a first to default swap basket have the same correlation in their probabilities of default. Similarly, investors realize that the naÃ¯ve assumption that there is no correlation between companies in different industries results in a substantial understatement of the risk in tranches of collateralized debt obligations. Even more important, investors realize that the correlation of the stock prices of a pair of companies is an inaccurate proxy for correlation of the default probabilities themselves. With the KRIS correlation service, investors can now easily download the exact historical correlations between the default probabilities of all pairs of companies in any user-defined portfolio," he added.
Kamakura offers three default probability models in its KRIS default probability service: a reduced form model developed by Professor Robert Jarrow, Kamakura's director research, an advanced version of the Merton model of risky debt, and a hybrid model. Kamakura has derived the macro-economic factors which best drive defaults through the credit cycle and has embedded these macro-economic factors in its default probability models. These macro factors are explicitly linked to default probabilities in the estimation process. AMR, parent of American Airlines, and British Airways showed an 82% correlation in their default probabilities over the last five years. Similarly, Citigroup and Goldman Sachs have experienced an 83% correlation in default probabilities, slightly lower than the correlation among credit spreads for the same two firms. Even across border, Citigroup has a 63% correlation with the default probabilities of UBS AG. Kamakura provides clients with a technical memorandum by Professor Jarrow which relates the correlation in default probabilities to the correlation of default events, a correlation which is always less than the correlation of default probabilities themselves.