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A Simple Model of Credit Contagion

by Daniel Egloff of Zürcher Kantonalbank,
Markus Leippold of the University of Zurich, and
Paolo Vanini of the University of Southern Switzerland & Zürcher Kantonalbank

September 22, 2005

Abstract: We propose a simple and easily implementable model of credit contagion in which we include macro- and microstructural interdependencies among the debtors within a credit portfolio. We show that even for diversified portfolios, moderate microstructural interdependencies have a significant impact on the tails of the loss distribution. This impact increases dramatically for less diversified microstructures. Since the inclusion of microstructural interdependencies acts on the tails, the choice of an appropriate risk measure for credit risk management is a delicate task.

JEL Classification: C19, C69, G18, G21.

Keywords: Credit Portfolio Risk Management, Contagion, Macroeconomic and Microstructural Interdependence, Value-at-Risk, Expected Shortfall.

Published in: Journal of Banking & Finance, Vol. 31, No. 8, (August 2007), pp. 2475-2492.

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