Credit risk model with contagious default dependencies affected by macro-economic condition

Hideyuki Takada and Ushio Sumita

European Journal of Operational Research, 2011, vol. 214, issue 2, 365-379

Abstract: We consider a credit risk model with two industrial sectors, where defaults of corporations would be influenced by two factors. The first factor represents the macro economic condition which would affect the default intensities of the two industrial sectors differently. The second factor reflects the influences of the past defaults of corporations against other active corporations, where such influences would affect the two industrial sectors differently. A two-layer Markov chain model is developed, where the macro economic condition is described as a birth-death process, while another Markov chain represents the stochastic characteristics of defaults with default intensities dependent on the state of the birth-death process and the number of defaults in two sectors. Although the state space of the two-layer Markov chain is huge, the fundamental absorbing process with a reasonable state space size could capture the first passage time structure of the two-layer Markov chain, thereby enabling one to evaluate the joint probability of the number of defaults in two sectors via the uniformization procedure of Keilson. This in turn enables one to value a variety of derivatives defined on the underlying credit portfolios. In this paper, we focus on a financial product called CDO, and a related option.

Keywords: Finance; Pricing; Risk; analysis; Systems; dynamics (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0377221711003857
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:214:y:2011:i:2:p:365-379

Access Statistics for this article

European Journal of Operational Research is currently edited by Roman Slowinski, Jesus Artalejo, Jean-Charles. Billaut, Robert Dyson and Lorenzo Peccati

More articles in European Journal of Operational Research from Elsevier
Bibliographic data for series maintained by Catherine Liu ().