A Structural Credit Risk Model with Default Contagion

Structural threshold models are common industry practice for modelling portfolio credit risk, but often only consider default dependence via underlying common factors. We consider a structural model extension that allows for additionally incorporating default contagion effects. A simulation study illustrates that ignoring default contagion effects may lead to significant underestimation of portfolio tail risk. As a key contribution, we propose a procedure for estimating default contagion parameters from historical default probability data.