Cyclical Correlations, Credit Contagion, and Portfolio Losses

by Kay Giesecke of Cornell University, and
Stefan Weber of Humboldt-Universität zu Berlin

December 2004

Abstract: We model aggregate credit losses on large portfolios of financial positions contracted with firms subject to both cyclical default correlation and direct default contagion processes. Cyclical correlation is due to the dependence of firms on common economic factors. Credit contagion phenomena are associated with the local interaction of firms with their business partners. We provide an explicit normal approximation of the distribution of total portfolio losses. We quantify the relation between the variability of global economic fundamentals, strength of local firm interaction, and the fluctuation of losses. We find that cyclical oscillations in fundamentals dominate average portfolio losses, while local interaction cause additional fluctuations of losses around their average. The strength of the contagion-induced loss variability and hence the degree of extreme loss risk depends on the complexity of the business partner network, a relation that was recently confirmed by empirical studies.

JEL Classification: G12, G13.

Keywords: cyclical correlation, credit contagion, portfolio losses, voter model, Bernoulli mixture model.

Published in: Journal of Banking & Finance, Vol. 28, No. 12, (December 2004), pp. 3009-3036.

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