Credit Risk in a Network Economy

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Credit Risk in a Network Economy

by Didier Cossin of IMD, Lausanne, and
Henry Schellhorn of Claremont Graduate University

October 4, 2006

Abstract: We develop a structural model of credit risk in a network economy, where any firm can lend to any other firm, so that each firm is subject to counterparty risk either from direct borrowers or from remote firms in the network. This model takes into account the role of each firm's cash management. We show that we can obtain a semi-closed form formula for the price of debt and equity when cash accounts are buffers to bankruptcy risk. As in other structural models, the strategic bankruptcy decision of shareholders drives credit spreads, and differentiates debt from equity. Cash flow risk also causes credit risk interdependencies between firms. Our model applies to the case where not only financial flows but also operations are dependent across firms. We use queueing theory to obtain our semi-closed form formulae in steady state. We perform a simplified implementation of our model to the US automotive industry and show how we infer the impact on a supplier's credit spreads of revenue changes in a manufacturer or even in a large car dealer.

JEL Classification: C16, C65, G12.

Keywords: Credit Risk, Contagion, Queueing Networks.

Previously titled: Default Risk in a Network Economy

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