Abstract

http://ssrn.com/abstract=2050499
 


 



Redesigning Credit Derivatives to Better Cover Sovereign Default Risk


Darrell Duffie


Stanford University - Graduate School of Business

Mohit Thukral


Stanford University

May 3, 2012

Rock Center for Corporate Governance at Stanford University Working Paper No. 118

Abstract:     
We propose a redesign of sovereign Credit Default Swaps (CDS). Under our proposal, a notional CDS position of €100 can be settled by the delivery of whatever package of instruments a sovereign gives in exchange for legacy bonds with a face value of €100. To illustrate, suppose a European sovereign restructures its debt by forcibly exchanging each €100 principal of legacy bonds for €50 principal of new bonds. In this case, our proposal would allow a notional CDS position of €100 to be settled by the delivery of new bonds with a principal of €50. We show that CDS protection payouts would then reflect actual losses to bondholders. We explain why the current CDS contract design fails this test, sometimes perversely, with adverse consequences for hedging performance and price discovery.

Published by Risk.net

Keywords: credit default swap (CDS), CDS contract design, credit derivatives, sovereign default risk, legacy bond exchanges, financial markets

JEL Classification: G30, E51

Accepted Paper Series


Not Available For Download

Date posted: May 4, 2012 ; Last revised: July 6, 2012

Suggested Citation

Duffie, Darrell and Thukral, Mohit, Redesigning Credit Derivatives to Better Cover Sovereign Default Risk (May 3, 2012). Rock Center for Corporate Governance at Stanford University Working Paper No. 118. Available at SSRN: http://ssrn.com/abstract=2050499 or http://dx.doi.org/10.2139/ssrn.2050499

Contact Information

James Darrell Duffie (Contact Author)
Stanford University - Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-723-1976 (Phone)
650-725-7979 (Fax)

Mohit Thukral
Stanford University ( email )
Stanford, CA 94305
United States
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