At a default correlation of 1, the reference entities in a basket behave effectively as one name, and at 0 they default independently of each other1. The higher the correlation, the lower the FTD spread1.

Default correlation cannot be observed directly, so prices reflect how market participants view its value2.

Notes

  1. Joro, Na and Niu (Proceedings of the 2004 Winter Simulation Conference), section 3 (page 2). ↩ ↩2

  2. Michael S. Gibson, "Understanding the Risk of Synthetic CDOs" (Federal Reserve Board, FEDS 2004-36, 2004), section 6 (page 18). ↩