Default Contagion in Large Homogeneous Portfolios

by Alexander Herbertsson of Göteborg University

November 10, 2007

Abstract: We study default contagion in large homogeneous credit portfolios. Using data from the iTraxx Europe series, two synthetic CDO portfolios are calibrated against their tranche spreads, index CDS spreads and average CDS spreads, all with five year maturity. After the calibrations, which render perfect fits, we investigate the implied expected ordered defaults times, implied default correlations, and implied multivariate default and survival distributions, both for ordered and unordered default times. Many of the numerical results differ substantially from the corresponding quantities in a smaller inhomogeneous CDS portfolio. Furthermore, the studies indicate that market CDO spreads imply extreme default clustering in upper tranches. The default contagion is introduced by letting individual intensities jump when other defaults occur, but be constant between defaults. The model is translated into a Markov jump process. Expressions for the investigated quantities are derived by using matrix-analytic methods.

JEL Classification: G33, G13, C02, C63, G32.

AMS Classification: 60J75, 60J22, 65C20, 91B28.

Keywords: Credit risk, intensity-based models, dependence modelling, default contagion, Markov jump processes, Matrix-analytic methods, synthetic CDO-s, index CDS-s.

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