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A dynamic default dependence model

Author

Listed:
  • Sara Cecchetti

    () (Bank of Italy)

  • Giovanna Nappo

    () (Sapienza, University of Rome)

Abstract

We 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 L�vy subordinators are used to model the dependence among default times. In particular, we define a cumulative dynamic hazard process as a L�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.

Suggested Citation

  • Sara Cecchetti & Giovanna Nappo, 2012. "A dynamic default dependence model," Temi di discussione (Economic working papers) 892, Bank of Italy, Economic Research and International Relations Area.
  • Handle: RePEc:bdi:wptemi:td_892_12
    as

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    File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2012/2012-0892/en_tema_892.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Donnelly, Catherine & Embrechts, Paul, 2010. "The Devil is in the Tails: Actuarial Mathematics and the Subprime Mortgage Crisis," ASTIN Bulletin: The Journal of the International Actuarial Association, Cambridge University Press, vol. 40(01), pages 1-33, May.
    3. Barbara Choroś-Tomczyk & Wolfgang Karl Härdle & Ludger Overbeck, 2014. "Copula dynamics in CDOs," Quantitative Finance, Taylor & Francis Journals, vol. 14(9), pages 1573-1585, September.
    4. Viktoriya Masol & Wim Schoutens, 2011. "Comparing alternative Levy base correlation models for pricing and hedging CDO tranches," Quantitative Finance, Taylor & Francis Journals, vol. 11(5), pages 763-773.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    L�vy subordinators; joint default probability; copula;

    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

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