Infectious Default Model with Recovery and Continuous Limit

Abstract

We introduce an infectious default and recovery model for N obligors. Obligors are assumed to be exchangeable and their states are described by N Bernoulli random variables S_{i} (i=1,...,N). They are expressed by multiplying independent Bernoulli variables X_{i},Y_{ij},Y'_{ij}, and default and recovery infections are described by Y_{ij} and Y'_{ij}. We obtain the default probability function P(k) for k defaults. Taking its continuous limit, we find two nontrivial probability distributions with the reflection symmetry of S_{i} \leftrightarrow 1-S_{i}. Their profiles are singular and oscillating and we understand it theoretically. We also compare P(k) with an implied default distribution function inferred from the quotes of iTraxx-CJ. In order to explain the behavior of the implied distribution, the recovery effect may be necessary.