Modeling the credit contagion channel and its consequences via the standard portfolio credit risk model

ABSTRACT Using actual default events for all listed firms of thirty economies over the period 2000 Q1 to 2011 Q2 and the technique of particle filtering and smoothing with the Markov chain Monte Carlo, we find strong evidence that defaults of small high-yield firms infect large high-yield firms, which, in turn, generates a contemporaneous feedback effect on small high-yield firms. We demonstrate that this type of credit contagion has a significant impact on the infected group's defaults and tail estimates of portfolio loss. All high-yield groups have systematic risk factors that exhibit a strong AR(1) effect, which is evidence of within-group default clustering. All investment-grade firms are not affected by this channel of credit contagion. In general, the lower grade high-yield firms have a higher default threshold in terms of asset value. Small firms are more vulnerable to default than large firms, and their defaults could serve as an early warning signal for system-wide credit contagion.