English

An SPDE Model for Systemic Risk with Endogenous Contagion

Probability 2018-10-02 v3 Mathematical Finance

Abstract

We propose a dynamic mean field model for `systemic risk' in large financial systems, which we derive from a system of interacting diffusions on the positive half-line with an absorbing boundary at the origin. These diffusions represent the distances-to-default of financial institutions and absorption at zero corresponds to default. As a way of modelling correlated exposures and herd behaviour, we consider a common source of noise and a form of mean-reversion in the drift. Moreover, we introduce an endogenous contagion mechanism whereby the default of one institution can cause a drop in the distances-to-default of the other institutions. In this way, we aim to capture key `system-wide' effects on risk. The resulting mean field limit is characterized uniquely by a nonlinear SPDE on the half-line with a Dirichlet boundary condition. The density of this SPDE gives the conditional law of a non-standard `conditional' McKean--Vlasov diffusion, for which we provide a novel upper Dirichlet heat kernel type estimate that is essential to the proofs. Depending on the realizations of the common noise and the rate of mean reversion, the SPDE can exhibit rapid accelerations in the loss of mass at the boundary. In other words, the contagion mechanism can give rise to periods of significant systemic default clustering.

Keywords

Cite

@article{arxiv.1801.10088,
  title  = {An SPDE Model for Systemic Risk with Endogenous Contagion},
  author = {Ben Hambly and Andreas Sojmark},
  journal= {arXiv preprint arXiv:1801.10088},
  year   = {2018}
}

Comments

44 pages, 5 page appendix, 4 figures; revised edition with improved presentation and updated proofs as well as some new content

R2 v1 2026-06-23T00:04:04.329Z