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Credit Risk in a Network Economy

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Author Info

  • Didier Cossin

    ()
    (IMD, CH-1001 Lausanne, Switzerland)

  • Henry Schellhorn

    ()
    (School of Mathematical Sciences, Claremont Graduate University, Claremont, California 91711)

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    Abstract

    We develop a structural model of credit risk in a network economy, where any firm can lend to any other firm, so that each firm is subject to counterparty risk either from direct borrowers or from remote firms in the network. This model takes into account the role of each firm's cash management. We show that we can obtain a semiclosed form formula for the price of debt and equity when cash accounts are buffers to bankruptcy risk. As in other structural models, the strategic bankruptcy decision of shareholders drives credit spreads, and differentiates debt from equity. Cash-flow risk also causes credit-risk interdependencies between firms. Our model applies to the case where not only financial flows but also operations are dependent across firms. We use queueing theory to obtain our semiclosed form formulae in steady state. We perform a simplified implementation of our model to the U.S. automotive industry, and show how we infer the impact on a supplier's credit spreads of revenue changes in a manufacturer or even in a large car dealer. We also obtain prices for first-to-default and second-to-default basket credit default swaps.

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    File URL: http://dx.doi.org/10.1287/mnsc.1070.0715
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 53 (2007)
    Issue (Month): 10 (October)
    Pages: 1604-1617

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    Handle: RePEc:inm:ormnsc:v:53:y:2007:i:10:p:1604-1617

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    Related research

    Keywords: credit risk; contagion; queueing networks;

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    Cited by:
    1. Diana Barro & Antonella Basso, 2008. "A network of business relations to model counterparty risk," Working Papers 171, Department of Applied Mathematics, Università Ca' Foscari Venezia.
    2. Sandoval, Leonidas Junior, 2013. "To lag or not to lag? How to compare indices of stock markets that operate at different times," Insper Working Papers wpe_319, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
    3. Ladley, Daniel, 2013. "Contagion and risk-sharing on the inter-bank market," Journal of Economic Dynamics and Control, Elsevier, vol. 37(7), pages 1384-1400.
    4. Shulin Zhang, & Ostap Okhrin, & Qian M. Zhou & Peter X.-K. Song, 2013. "Goodness-of-fit Test for Specification of Semiparametric Copula Dependence Models," SFB 649 Discussion Papers SFB649DP2013-041, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    5. Wenlang Zhang & Gaofeng Han & Steven Chan, 2014. "How Strong are the Linkages between Real Estate and Other Sectors in China?," Working Papers 112014, Hong Kong Institute for Monetary Research.
    6. Spiros Bougheas & Alan Kirman, 2014. "Complex Financial Networks and Systemic Risk: A Review," Discussion Papers 2014/04, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).

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