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Mastering Credit Derivatives: A step-by-step guide to credit derivatives and structured credit, Second Edition by Andrew Kasapis

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Chapter 6. What is correlation?

Before addressing correlation, it is worth saying why correlation is of interest to credit investors. Portfolio structured credit products are generally based on portfolios of assets whose performance is interrelated. For example, default rates are economically cyclical and entire sectors can suffer from downturns, resulting in more defaults than expected. These baskets of correlated assets behave differently from identical baskets of independent assets. For example, retailers such as Tesco and Wal-Mart are correlated assests, but one is in the UK, the other in the US. Markets have long since recognized these differences and prices have reflected the different risks. Correlation[1] is the missing link between today’s ...

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