Credit contagion

Abstract

Credit contagion arises when a company is in economic distress or if it defaults. The default of a company will have implications for any firm that is economically connected to this given company. The effect of the default, and thus the effect of the credit contagion, depends on which economic relation the defaulting company has with other firms. Default is an element of credit risk. Modeling credit risk is importaint when it comes to the modeling of derivative pricing, such as the prices of credit default swaps, (CDS), and collateral debt obligations, (CDO). These forms of derivatives have been largely talked about during the latest financial crisis since, among others, credit rating agencies (which evaluate the default probability of issuers of debt securities) failed to adequately account for large risks when rating these products. There are roughly two approaches to model credit risk; structural modeling and intensity based modeling. In the intensity based models (also known as reduced form models) default is typically described as a jump time of a jump process (for instance a Poisson process). This thesis is looking at one contagion model in discrete time and one in continuous time, where both are intensity based models.