Information-Driven Default Contagion

Much of the existing literature on dafault contagion assume a direct causal relationships between two obligors' defaults. Schonbucher(2003) present a model in which default contagion arises without causal links solely from information effects. In this model, investors have only incomplete information about the true size of any obligors' risk of default. The true default risk depends on a number of variables which none of the market participants can observe directly. Furthermore, many of these hidden variables maybe correlated across obligors. However, they are notoriously difficult to estimate and quantify, almost all of them carry large estimation errors. Thus, Schonbucher(2003) use proportional hazards model asuming that the default hazard rates are not fully observable but they carry a multiplicative error term Y, i.e. h_i = Y_iλ_i. where Y is a continuous nonnegative random variable.This paper present an extension of the Schonbucher(2003) model, with the assumption that the default time obeying Γ-distribution and the scale parameter β_i = Y_iλ_i. For exhibating contagion properties, we assume all Y_i are equal. Under different information , the obligors' survival porbabilities and default hazard rates are discussed. Finally, we price the first default bonds.