Modeling Credit Contagion via the Updating of Fragile Beliefs

65 Pages Posted: 5 Mar 2012 Last revised: 29 Jan 2015

See all articles by Luca Benzoni

Luca Benzoni

Federal Reserve Bank of Chicago - Research Department

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute; National Bureau of Economic Research (NBER)

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)

Jean Helwege

UC Riverside

Multiple version iconThere are 2 versions of this paper

Date Written: January 17, 2015

Abstract

We propose an equilibrium model for defaultable bonds that are subject to contagion risk. Contagion arises because agents with "fragile beliefs'' are uncertain about the underlying economic state and its probability. Estimation on sovereign European credit default swaps (CDS) data shows that agents require a time-varying risk premium for bearing state uncertainty. The model outperforms affine specifications with the same number of state variables, suggesting that there are important nonlinearities in credit spreads that are captured by our model. Contagion drives most of the variation in CDS spreads, especially before the crisis. However, economic fundamentals account for a significant fraction during the crisis.

The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2555693

Keywords: Contagion, sovereign risk, CDS pricing, fragile beliefs, learning, affine models

JEL Classification: G12, G13

Suggested Citation

Benzoni, Luca and Collin-Dufresne, Pierre and Goldstein, Robert S. and Helwege, Jean, Modeling Credit Contagion via the Updating of Fragile Beliefs (January 17, 2015). Available at SSRN: https://ssrn.com/abstract=2016579 or http://dx.doi.org/10.2139/ssrn.2016579

Luca Benzoni (Contact Author)

Federal Reserve Bank of Chicago - Research Department ( email )

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HOME PAGE: http://lbenzoni.frbchi.googlepages.com/

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne ( email )

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National Bureau of Economic Research (NBER)

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Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Jean Helwege

UC Riverside ( email )

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Riverside, CA 92521
United States
9518274284 (Phone)

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