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Estimating Credit Contagion in a Standard Factor Model

by Daniel Rösch of the University of Regensburg, and
Birker Winterfeldt of the University of Regensburg

January 30, 2007

Abstract: State-of-the-art credit risk portfolio models and the New Basel Capital Accord consider only symmetric dependencies between borrowers in a portfolio, such as correlations. Recently, asymmetric dependencies have been introduced by Davis/Lo (2001) among others. However, statistical estimation techniques and empirical evidence on contagion is still rather scarce. The present paper provides a simple credit risk portfolio model extension to credit contagion and shows how its parameters can be easily estimated and tested. We apply our methodology to a dataset provided by Moody's Investor Services and find significant contagion effects. By stress testing we show how contagion can seriously affect credit losses.

JEL Classification: G20, G28, C51.

Keywords: Credit Risk Models, Credit Contagion, Stress Testing.

Published in: Risk, Vol. 21, No. 8, (August 2008), pp. 66-71.

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