Temporal Coarse-Graining of Latent Default-Probability Paths Generates Effective Default Correlation

Abstract

We show that persistent dynamics of a latent default-probability path can generate effective default correlation through temporal coarse-graining. In the OU--Binomial baseline, monthly defaults are conditionally independent given this latent path, but aggregating monthly default probabilities into long-horizon probabilities induces a scale-dependent effective mixing distribution for aggregated default counts. Applied to corporate default-count data, this mechanism explains long-horizon overdispersion, autocorrelation, and the emergence of effective default correlation. We then examine Davis--Lo-type contagion and Vasicek-type common-factor extensions. Direct fitting at each aggregation scale assigns increasing residual covariance shares to instantaneous dependence, but worsens the per-block expected log predictive density. In contrast, when monthly posterior latent paths are first coarse-grained and residual-dependence parameters are estimated conditional on these paths, the residual covariance contributions remain small while the predictive density improves. Thus, temporal coarse-graining provides a scale-consistent baseline that regularizes the attribution of variance and improves identifiability by suppressing the over-allocation of long-horizon fluctuations to contagion or asset-correlation parameters.