A New Risk Indicator and Stress Testing Tool: A Multifactor Nth-to-Default CDS Basket
25 Pages Posted: 21 Jun 2006
Date Written: April 2006
Abstract
This paper generalizes a market-based indicator for financial sector surveillance using a multifactor latent structure in the determination of the default probabilities of an nth-to-default credit default swap (CDS) basket of large complex financial institutions (LCFIs). To estimate the multifactor latent structure, we link the market risk (the covariance of the LCFIs' equity) to credit risk (the default probability of the CDS basket) in a coherent manner. In addition, to analyze the response of the probabilities of default to changing macroeconomic conditions, we run a stress test by generating shocks to the latent multifactor structure. The results unveil a rich set of default probability dynamics and help in identifying the most relevant sources of risk. We anticipate that this approach could be of value to financial supervisors and risk managers alike.
Keywords: Risk management, market indicators, stress testing, credit default swap (CDS), collateralized debt obligation (CDO), credit risk, large complex financial institutions (LCFIs)
JEL Classification: G11, G13, G15, G21, G24
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Comovements in the Prices of Securities Issued by Large Complex Financial Institutions
By Christian B. Hawkesby, Ian W. Marsh, ...
-
Global Business Cycles and Credit Risk
By M. Hashem Pesaran, Björn-jakob Treutler, ...
-
First: A Market-Based Approach to Evaluate Financial System Risk and Stability