Default Contagion in a Two-Tree Economy

44 Pages Posted: 5 May 2021

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Alexandre Jeanneret

UNSW Business School

Yiliu Lu

McGill University, Desautels Faculty of Management, Students

Date Written: May 5, 2021

Abstract

We propose an explanation for default contagion based on a Lucas model with two independent debt-financed trees. The transmission mechanism is that variations in the size of one tree impact the level of risk premium and the default decision for all borrowers. If a negative shock hits one tree, the other tree contributes to a larger proportion of aggregate consumption and thus bears more systematic risk. The resulting higher risk premium increases the cost of debt and tilts that borrower's decision towards default. This mechanism induces contagion in default probabilities, leverage, and financial volatility across borrowers with uncorrelated fundamentals. The effect is stronger for borrowers with greater rollover needs.

Keywords: Contagion, Asset Prices, Credit Risk, Leverage, Volatility

JEL Classification: G12, G13

Suggested Citation

Ericsson, Jan and Jeanneret, Alexandre and Lu, Yiliu, Default Contagion in a Two-Tree Economy (May 5, 2021). Available at SSRN: https://ssrn.com/abstract=3839885

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Alexandre Jeanneret

UNSW Business School ( email )

Sydney, NSW 2052
Australia

Yiliu Lu

McGill University, Desautels Faculty of Management, Students ( email )

1001 Sherbrooke St. West
Montreal
Canada

HOME PAGE: http://https://www.mcgill.ca/desautels/yiliu-lu

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