Financial Simulation Modeling in Excel

CORRELATION IN A FINANCIAL CONTEXT

We have just looked at how correlation is calculated using an easy to understand example, provided historical data, but what is important to simulation is how correlation is used for future projections. If we believe there is a correlation between items that we are simulating, we will have to account for it in our simulation; otherwise the end results can be very different.

The two most common areas that correlation enters into financial simulations are industry- and regional-based correlations. For instance, if we are invested in a telecommunications company and the telecommunications industry as a whole is in decline, we would expect a correlation in the performance of our individual telecommunication company investment. Likewise, if we are invested in a company that services Asian markets and Asian markets are in decline, we might expect our individual invested company to experience decline because of the regional correlation. Let's take a look at a simple simulation of 10 corporate loans with a single correlation factor and see how the correlation affects the expected default of the basket of loans.

MODEL BUILDER 3.2: Introducing Correlation in a Basic Corporate Default Model

1. This Model Builder expands off of our basic correlation coefficient calculation and shows how correlation can affect the results of a simulation. In this example there are 10 assumed exposures that are from different companies, but all maintain the same risk profile ...