Credit Risk Contagion and Mitigation for Guaranty Portfolio

This paper establish a structural model framework to analyze the mitigation and contagion effect of guaranty portfolio, especially on reserve and capital allocation. Contagion is modeled as adjusting default barrier in Merton´s structural model, while mitigation is modeled as delayed potential loss. Expected and unexpected losses are evaluated in this framework. Numerical analysis shows that guaranty can effectively reduce the amount of expected loss while only relatively small amount of more unexpected loss is incurred due to default contagion.