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Large Portfolio Losses: A dynamic contagion model

by Paolo Dai Pra of the University of Padova,
Wolfgang J. Runggaldier of the University of Padova,
Elena Sartori of the University of Padova, and
Marco Tolotti of Bocconi University

March 4, 2009

Abstract: Using particle system methodologies we study the propagation of financial distress in a network of firms facing credit risk. We investigate the phenomenon of a credit crisis and quantify the losses that a bank may suffer in a large credit portfolio. Applying a large deviation principle we compute the limiting distributions of the system and determine the time evolution of the credit quality indicators of the firms, deriving moreover the dynamics of a global financial health indicator. We finally describe a suitable version of the "Central Limit Theorem" useful to study large portfolio losses. Simulation results are provided as well as applications to portfolio loss distribution analysis.

Keywords: Credit contagion, credit crisis, interacting particle systems, Large Deviations, large portfolio losses, mean field interaction, non reversible Markov processes, phase transition.

Published in: Annals of Applied Probability, Vol. 19, No. 1, (February 2009), pp. 347-394.

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