wilmott.com

In the book "Credit Derivatives - the definitive guide" by Jon Gregory the formula to produce correlated random shocks is given as: Ri = (SQRT(rho))*Rm + (SQRT((1-rho))*EiIs this wrong? When I implement this the correlations don't match my targets... However, if i use the following formual they do match the targets: Ri = (rho)*Rm + (SQRT((1-rho^2))*EiShould i just throw the book in the bin? Cheers,

The two formula are correct: ie Ri has variance 1 in both cases, assuming Rm and Ei have variance 1. They only differ in term of the correlation parameter between Ri and Rj, in the first case:corr(Ri,Rj)=rhowhile in the secondcorr(Ri,Rj)=rho^2

Thanks Meteor,However, when I implement this, the second version gives me correlations equal to rho....Could you show me the proof?

here you go

Many thanks.