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Credit contagion and aggregate losses

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  • Giesecke, Kay
  • Weber, Stefan

Abstract

Credit contagion refers to the propagation of economic distress from one firm or sovereign government to another. In this paper we model credit contagion phenomena and study the fluctuation of aggregate credit losses on large portfolios of financial positions. The joint dynamics of firms' credit ratings is modeled by a voter process, which is well-known in the theory of interacting particle systems. We clarify the structure of the equilibrium joint rating distribution using ergodic decomposition. We analyze the quantiles of the portfolio loss distribution and in particular their relation to the degree of model risk. After a proper re-scaling taking care of the heavy tails induced by the contagion dynamics, we provide a normal approximation of both the equilibrium rating distribution and the portfolio loss distribution.

Suggested Citation

  • Giesecke, Kay & Weber, Stefan, 2002. "Credit contagion and aggregate losses," SFB 373 Discussion Papers 2002,73, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    • Handle: RePEc:zbw:sfb373:200273
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    References listed on IDEAS

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    1. Giesecke, Kay, 2001. "Correlated default with incomplete information," SFB 373 Discussion Papers 2002,30, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    2. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    3. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    4. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
    5. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
    6. Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-638, August.
    7. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," The Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    8. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515, World Scientific Publishing Co. Pte. Ltd..
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    Citations

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    Cited by:

    1. Drew Dahl & Andrew Logan, 2005. "The exposure of international bank loans to third-country risk: an empirical analysis of overdue claims," Bank of England working papers 247, Bank of England.
    2. Neu, Peter & Kühn, Reimer, 2004. "Credit risk enhancement in a network of interdependent firms," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 342(3), pages 639-655.
    3. Dahl, Drew & Logan, Andrew, 2007. "The exposure of international banks to cross-country interdependencies: An empirical analysis of overdue claims," Journal of Multinational Financial Management, Elsevier, vol. 17(3), pages 203-213, July.
    4. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    5. Giesecke, Kay & Weber, Stefan, 2004. "Cyclical correlations, credit contagion, and portfolio losses," Journal of Banking & Finance, Elsevier, vol. 28(12), pages 3009-3036, December.
    6. Leippold, Markus & Vanini, Paolo & Ebnoether, Silvan, 2006. "Optimal credit limit management under different information regimes," Journal of Banking & Finance, Elsevier, vol. 30(2), pages 463-487, February.
    7. Nystrom, Kaj & Skoglund, Jimmy, 2006. "A credit risk model for large dimensional portfolios with application to economic capital," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2163-2197, August.
    8. Giesecke, Kay & Weber, Stefan, 2003. "Cyclical correlations, credit contagion, and portfolio losses," SFB 373 Discussion Papers 2003,11, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.

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