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In Rememberance: World Trade Center (WTC)

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Information-driven Default Contagion

by Philipp J. Schönbucher of ETH Zürich

December 2003

Abstract: Much of the existing literature on default contagion assumes a direct causal relationships between two obligors' defaults. In this paper we present a model in which default contagion arises without causal links solely from information effects if investors are imperfectly informed about some common factors affecting the true riskiness of the obligors. We model this effect in a simple extension of the intensity-based modelling framework using unobserved frailty variables. If one obligor defaults in this model, the default intensities of other obligors exhibit jumps which are proportional to the covariances of the corresponding frailties. This allows the modelling of much higher (and more realistic) levels of default dependence between the obligors than what purely diffusion-based intensity models were able to capture previously, without adding too much additional complexity. The parameters of the dependence can be implied directly from spread jumps observed in the market, thus enabling a full specification of the model under pricing probabilities without recourse to historical default correlations. We furthermore present an extension of the model in which the size of the contagion effect can depend on the reason for the default and not just the identity of the defaulted obligor, thus introducing stochastic dependency.

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