Credit Contagion and Aggregate Losses

by Kay Giesecke of Cornell University, and
Stefan Weber of the Technische Universität Berlin

May 2006

Abstract: Credit contagion refers to the propagation of economic distress from one firm or sovereign government to another. In this paper we model credit contagion phenomena and study the fluctuation of aggregate credit losses on large portfolios of financial positions. The joint dynamics of firms' credit ratings is modeled by a voter process, which is well-known in the theory of interacting particle systems. We clarify the structure of the equilibrium joint rating distribution using ergodic decomposition. We analyze the quantiles of the portfolio loss distribution and in particular their relation to the degree of model risk. After a proper re-scaling taking care of the heavy tails induced by the contagion dynamics, we provide a normal approximation of both the equilibrium rating distribution and the portfolio loss distribution.

JEL Classification: G11, G31.

Keywords: credit contagion, portfolio losses, voter model, Choquet theory, ergodic decomposition, re-scaling.

Published in: Journal of Economic Dynamics and Control, Vol. 30, No. 5, (May 2006), pp. 741-767.

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