A structural framework for network-based default contagion in credit portfolios

International Journal of Financial Engineering, vol. 13

Abstract

Portfolio credit risk models typically incorporate the default dependence between obligors that arises from common risk factors. However, they often ignore obligor-to-obligor default contagion effects, which can propagate through economic networks. We present a structural framework that can be layered onto existing factor models to capture higher-order network-based default contagion. Our approach yields efficient and tractable computations that are applicable to heterogeneous singly connected networks, which can represent empirically observed dependence structures such as supply chains, corporate groups and hierarchical governments. As a key contribution, we develop an expectation-maximization algorithm that estimates default contagion parameters from historical creditworthiness information. Our simulation-based numerical results show that the impact of default contagion on risk measures is well estimated by our framework.

Authors 4

1. B. Schiphorst

   University of Amsterdam

   Affiliation as printed

   Korteweg–de Vries Institute for Mathematics, University of Amsterdam, Amsterdam, Science Park 107, 1098XH, The Netherlands

   Rabobank, Utrecht, Croeselaan 18, 3521CB, The Netherlands

2. Michel Mandjes Aachen Mathematical Institute

   Leiden University · University of Amsterdam

   Affiliation as printed

   Korteweg–de Vries Institute for Mathematics, University of Amsterdam, Amsterdam, Science Park 107, 1098XH, The Netherlands

   Mathematical Institute, Leiden University, Leiden, P. O. Box 512, 2300RA, The Netherlands

3. Peter Spreij

   Radboud University Nijmegen · University of Amsterdam

   Affiliation as printed

   IMAPP, Radboud University, Nijmegen, Heyendaalseweg 135, 6525AJ, The Netherlands

   Korteweg–de Vries Institute for Mathematics, University of Amsterdam, Amsterdam, Science Park 107, 1098XH, The Netherlands

4. E.M.M. Winands

   University of Amsterdam

   Affiliation as printed

   Korteweg–de Vries Institute for Mathematics, University of Amsterdam, Amsterdam, Science Park 107, 1098XH, The Netherlands

   Rabobank, Utrecht, Croeselaan 18, 3521CB, The Netherlands