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Cyclical correlations, credit contagion, and portfolio losses

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  • Giesecke, Kay
  • Weber, Stefan
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    Abstract

    We model aggregate credit losses on large portfolios of financial positions contracted with firms subject to both cyclical default correlation and direct default contagion processes. Cyclical correlation is due to the dependence of firms on common (macro-) economic factors; credit contagion phenomena are associated with the local interaction of firms with their business partners. We provide an explicit normal approximation of the distribution of total portfolio losses, which is the key to the measurement and management of aggregated credit loss risk. Based on this result we quantify the relation between the variability of global economic fundamentals, strength of local interaction between firms, and the fluctuation of portfolio losses. In particular, we find that cyclical oscillations in fundamentals dominate average portfolio losses, while local firm interaction and the associated contagion processes cause additional fluctuations of losses around their average. The strength of the contagion-induced loss variability and hence the degree of extreme loss risk depends on the complexity of the business partner network, a relation that was recently confirmed by empirical studies. --

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    Bibliographic Info

    Paper provided by Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes in its series SFB 373 Discussion Papers with number 2003,11.

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    Date of creation: 2003
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    Handle: RePEc:zbw:sfb373:200311

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    Related research

    Keywords: cyclical correlation; credit contagion; portfolio losses; voter model; Bernoulli mixture model;

    References

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    1. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January.
    2. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
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    Cited by:
    1. Siem Jan Koopman & Andr´┐Ż Lucas, 2003. "Business and Default Cycles for Credit Risk," Tinbergen Institute Discussion Papers 03-062/2, Tinbergen Institute, revised 09 Jan 2003.

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