Cyclical correlations, credit contagion, and portfolio losses

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 economic factors. Contagion is associated with the local interaction of firms with their business partners. We provide an explicit normal approximation of the distribution of portfolio losses. We quantify the relation between the variability of global economic fundamentals, strength of local firm interaction, and the fluctuation of losses. We find that cyclical oscillations in fundamentals dominate average losses, while local interaction causes additional fluctuations of losses around their average. The strength of the contagion-induced loss variability depends on the complexity of the business partner network. 2003 Elsevier B.V. All rights reserved. JEL classification: G12; G13