A contagion process with self-exciting jumps in credit risk applications

Abstract

The modeling of the probability of joint default or total number of defaults among the firms is one of the crucial problems to mitigate the credit risk since the default correlations significantly affect the portfolio loss distribution and hence play a significant role in allocating capital for solvency purposes. In this article, we derive a closed-form expression for the default probability of a single firm and probability of the total number of defaults by time $t$ in a homogeneous portfolio. We use a contagion process to model the arrival of credit events causing the default and develop a framework that allows firms to have resistance against default unlike the standard intensity-based models. We assume the point process driving the credit events is composed of a systematic and an idiosyncratic component, whose intensities are independently specified by a mean-reverting affine jump-diffusion process with self-exciting jumps. The proposed framework is competent of capturing the feedback effect. We further demonstrate how the proposed framework can be used to price synthetic collateralized debt obligation (CDO). Finally, we present the sensitivity analysis to demonstrate the effect of different parameters governing the contagion effect on the spread of tranches and the expected loss of the CDO.