A dynamic default dependence model
AbstractWe develop a dynamic multivariate default model for a portfolio of credit-risky assets in which default times are modelled as random variables with possibly different marginal distributions, and LÃ©vy subordinators are used to model the dependence among default times. In particular, we define a cumulative dynamic hazard process as a LÃ©vy subordinator, which allows for jumps and induces positive probabilities of joint defaults. We allow the main asset classes in the portfolio to have different cumulative default probabilities and corresponding different cumulative hazard processes. Under this heterogeneous assumption we compute the portfolio loss distribution in closed form. Using an approximation of the loss distribution, we calibrate the model to the tranches of the iTraxx Europe. Once the multivariate default distribution has been estimated, we analyse the distress dependence in the portfolio by computing indicators of systemic risk, such as the Stability Index, the Distress Dependence Matrix and the Probability of Cascade Effects.
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Bibliographic InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 892.
Date of creation: Nov 2012
Date of revision:
LÃ©vy subordinators; joint default probability; copula;
Find related papers by JEL classification:
- B26 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Financial Economics
- C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-12-22 (All new papers)
- NEP-BAN-2012-12-22 (Banking)
- NEP-CBA-2012-12-22 (Central Banking)
- NEP-RMG-2012-12-22 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Elisa Luciano, 2007. "Copula-Based Default Dependence Modelling: Where Do We Stand?," ICER Working Papers - Applied Mathematics Series 21-2007, ICER - International Centre for Economic Research.
- Jan-Frederik Mai & Matthias Scherer, 2009. "A Tractable Multivariate Default Model Based On A Stochastic Time-Change," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(02), pages 227-249.
- Viktoriya Masol & Wim Schoutens, 2011. "Comparing alternative Levy base correlation models for pricing and hedging CDO tranches," Quantitative Finance, Taylor and Francis Journals, vol. 11(5), pages 763-773.
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