Portfolio loss modeling: an infectious framework

This paper introduces a new model that takes inspiration from the approach of Davis and Lo (2001) but differentiates from it by relaxing the homogeneous assumption and by introducing few restrictions on the shape of the infection mechanism that allow for a good level of tractability. In particular, the contagion mechanism proposed is the result of two independent components: an infection attempt generated by defaulting frms and a failed defense from healthy ones. Within this framework it is possible to prove several theoretical results regarding marginal default probabilities and joint default/survival events. Finally, we provide an effcient recursive algorithm for the portfolio loss distribution similar, in spirit, to the one commonly used for CID (conditionally independent) models.