Mathematical Finance Seminar
February 20, 2003 , 5:30 PM to 7:00 PM
Kay Giesecke, Cornell University
Credit Contagion and Aggregate Losses
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.