Contagion effect on bond portfolio risk measures in a hybrid credit risk model

•Modelling the contagion changes the risk perception associated to a bond portfolio.•The model includes recovery rate risk.•Dependence produces clusters of defaults with low recovery rates.•Modelling and measuring contagion have a major impact on standard risk measures.

This paper illustrates how modelling the contagion effect among assets of a given bond portfolio changes the risk perception associated to it. This empirical work is developed in a hybrid credit risk framework that incorporates recovery rate risk. Dependence structures among firms and between external shocks affecting firms together are considered. The presence of correlations among firm leverage ratios and the interrelation between default probabilities and recovery rates produces clusters of defaults with low recovery rates. This has a major impact on standard risk measures such as Value-at-Risk and conditional tail expectation. Consequently, an appropriate measurement of the contagion has a tremendous effect on the capital requirement of many financial institutions.