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arXiv · 1604.07042

Entropy and credit risk in highly correlated markets

Sylvia Gottschalk
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Abstract

We compare two models of corporate default by calculating the Jeffreys-Kullback-Leibler divergence between their predicted default probabilities when asset correlations are either high or low. Our main results show that the divergence between the two models increases in highly correlated, volatile, and large markets, but that it is closer to zero in small markets, when asset correlations are low and firms are highly leveraged. These findings suggest that during periods of financial instability the single-and multi-factor models of corporate default will generate increasingly inconsistent predictions.

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Sylvia Gottschalk. 2016-04-24. Entropy and credit risk in highly correlated markets. https://doi.org/10.1016/j.physa.2017.02.083

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