A Markovian infectious model for dependent default risk

Jia-Wen Gu, Wai-Ki Ching, Tak-Kuen Siu

Research output: Contribution to journalArticle

Abstract

Modelling dependent defaults has long been a central issue for credit risk measurement and management. To address this important issue, we introduce a Markovian infectious model to describe the dependent relationship of default processes of credit securities. The central tenant of the proposed model is the concept of common shocks which is one of the major approaches to describe insurance risk. Using real data default data, we compare the proposed model to some existing default risk models, such as one-sector and two-sector models discussed in Ching et al. (2008, 2010). A log likelihood ratio test is adopted for the purpose of model comparison. Our empirical results reveal that the proposed model outperforms both the one-sector and two-sector models. We also illustrate the application of the proposed model for quantitative risk measurement. In particular, numerical results for both the crisis value-at-risk and the crisis expected shortfall are provided.
Original languageEnglish
Pages (from-to)174-195
Number of pages22
JournalInternational journal of intelligent engineering informatics
Volume1
Issue number2
DOIs
Publication statusPublished - 2011

Keywords

  • dependent default risk
  • Markovian infectious models
  • common shocks
  • multi-sector models
  • chain reaction
  • crisis risk measures

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