A Dynamic Contagion Risk Model With Recovery Features
49 Pages Posted: 13 Aug 2019 Last revised: 4 Aug 2020
Date Written: August 9, 2019
We introduce threshold growth in the classical threshold contagion model, or equivalently a network of Cramer-Lundberg processes in which nodes have downward jumps when there is a failure of a neighboring node. Choosing the configuration model as underlying graph, we prove fluid limits for the baseline model, as well as extensions to the directed case, state-dependent inter-arrival times and the case of growth driven by upward jumps.
We obtain explicit ruin probabilities for the nodes according to their characteristics: initial threshold and in- (and out-) degree.
We then allow nodes to choose their connectivity by trading off link benefits and contagion risk. We define a rational equilibrium concept in which nodes choose their connectivity according to an expected failure probability of any given link, and then impose condition that the expected failure probability coincides with the actual failure probability under the optimal connectivity.
We show existence of an asymptotic equilibrium as well as convergence of the sequence of equilibria on the finite networks.
In particular, our results show that systems with higher overall growth may have higher failure probability in equilibrium.
Keywords: collective risk theory, systemic risk, default contagion
JEL Classification: G01, G18
Suggested Citation: Suggested Citation