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Modeling credit contagion via the updating of fragile beliefs

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  • Luca Benzoni
  • Pierre Collin-Dufresne
  • Robert S. Goldstein
  • Jean Helwege
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    Abstract

    We propose a tractable equilibrium model for pricing defaultable bonds that are subject to contagion risk. Contagion arises because agents with ‘fragile beliefs’ are uncertain about both the underlying state of the economy and the posterior probabilities associated with these states. As such, agents adopt a robust decision rule for updating that leads them to over-weight the posterior probabilities of ‘bad’ states. We estimate the model using panel data on sovereign Euro-zone CDS spreads during the recent crisis, and find that it captures levels and dynamics of spreads better than traditional affine models with the same number of observable and latent state variables.

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    File URL: http://www.chicagofed.org/digital_assets/publications/working_papers/2012/wp2012_04.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-2012-04.

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    Date of creation: 2012
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    Handle: RePEc:fip:fedhwp:wp-2012-04

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    Related research

    Keywords: Bonds - Prices ; Europe - Economic conditions ; Eurozone;

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    References

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