Cyclical correlations, credit contagion, and portfolio losses

Abstract

We model aggregate credit losses on large portfolios of financial positions contracted with firms subject to both cyclical default correlation and direct default contagion processes. Cyclical correlation is due to the dependence of firms on common (macro-) economic factors; credit contagion phenomena are associated with the local interaction of firms with their business partners. We provide an explicit normal approximation of the distribution of total portfolio losses, which is the key to the measurement and management of aggregated credit loss risk. Based on this result we quantify the relation between the variability of global economic fundamentals, strength of local interaction between firms, and the fluctuation of portfolio losses. In particular, we find that cyclical oscillations in fundamentals dominate average portfolio losses, while local firm interaction and the associated contagion processes cause additional fluctuations of losses around their average. The strength of the contagion-induced loss variability and hence the degree of extreme loss risk depends on the complexity of the business partner network, a relation that was recently confirmed by empirical studies.