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An extension of Davis and Lo's contagion model

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  • Areski Cousin
  • Diana Dorobantu
  • Didier Rulli�re

Abstract

The present paper provides a multi-period contagion model in the credit risk field. Our model is an extension of Davis and Lo's infectious default model. We consider an economy of n firms that may default directly or may be infected by other defaulting firms (a domino effect also being possible). Spontaneous defaults without external influence and infection are described by not necessarily independent Bernoulli-type random variables. Moreover, several sources of contamination could be required to infect another firm. In this paper we compute the probability distribution function of the total number of defaults in a dependency context. We also give a simple recursive algorithm to compute this distribution in an exchangeability context. Numerical applications illustrate the impact of exchangeability among direct defaults and among contaminations, on different indicators calculated from the law of the total number of defaults. We then calibrate the model on iTraxx data before and during the crisis. The dynamic feature together with the contagion effect have a significant impact on the model performance, especially during the recent distressed period.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 13 (2013)
Issue (Month): 3 (February)
Pages: 407-420

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Handle: RePEc:taf:quantf:v:13:y:2013:i:3:p:407-420

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  1. Denuit, Michel & Lefevre, Claude & Utev, Sergey, 2002. "Measuring the impact of dependence between claims occurrences," Insurance: Mathematics and Economics, Elsevier, vol. 30(1), pages 1-19, February.
  2. Egloff, Daniel & Leippold, Markus & Vanini, Paolo, 2007. "A simple model of credit contagion," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2475-2492, August.
  3. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
  4. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, vol. 56(5), pages 1765-1799, October.
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  6. Jorion, Philippe & Zhang, Gaiyan, 2007. "Good and bad credit contagion: Evidence from credit default swaps," Journal of Financial Economics, Elsevier, vol. 84(3), pages 860-883, June.
  7. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
  8. Fan Yu, 2007. "Correlated Defaults In Intensity-Based Models," Mathematical Finance, Wiley Blackwell, vol. 17(2), pages 155-173.
  9. Herbertsson, Alexander, 2007. "Pricing Synthetic CDO Tranches in a Model with Default Contagion Using the Matrix-Analytic Approach," Working Papers in Economics 270, University of Gothenburg, Department of Economics.
  10. Philippe Jorion & Gaiyan Zhang, 2010. "Information Transfer Effects of Bond Rating Downgrades," The Financial Review, Eastern Finance Association, vol. 45(3), pages 683-706, 08.
  11. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
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  13. Friedel Epple & Sam Morgan & Lutz Schloegl, 2007. "Joint Distributions Of Portfolio Losses And Exotic Portfolio Products," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 733-748.
  14. Giesecke, Kay & Weber, Stefan, 2004. "Cyclical correlations, credit contagion, and portfolio losses," Journal of Banking & Finance, Elsevier, vol. 28(12), pages 3009-3036, December.
  15. Boissay, Frédéric, 2006. "Credit chains and the propagation of financial distress," Working Paper Series 0573, European Central Bank.
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Cited by:
  1. Patrick Gagliardini & Christian Gouriéroux, 2012. "Correlated Risks vs Contagion in Stochastic Transition Models," Working Papers 2012-07, Centre de Recherche en Economie et Statistique.
  2. Stéphane Loisel & Pierre Arnal & Romain Durand, 2010. "Correlation crises in insurance and finance, and the need for dynamic risk maps in ORSA," Working Papers hal-00502848, HAL.
  3. Gagliardini, Patrick & Gouriéroux, Christian, 2013. "Correlated risks vs contagion in stochastic transition models," Journal of Economic Dynamics and Control, Elsevier, vol. 37(11), pages 2241-2269.

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