Modeling Credit Contagion Via the Updating of Fragile Beliefs

54 Pages Posted: 24 Nov 2012 Last revised: 13 Jan 2016

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: February 14, 2014

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 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.

Suggested Citation

Benzoni, Luca and Collin-Dufresne, Pierre and Goldstein, Robert S. and Helwege, Jean, Modeling Credit Contagion Via the Updating of Fragile Beliefs (February 14, 2014). Netspar Discussion Paper No. 12/2011-123 - revised version February 2014. Available at SSRN: https://ssrn.com/abstract=2179931 or http://dx.doi.org/10.2139/ssrn.2179931

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
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