Counterparty Risk Management with Market-Based Indicators: Lessons from the Crisis
27 Pages Posted: 18 Dec 2009 Last revised: 22 Feb 2010
Date Written: December 30, 2009
During a financial crisis, which counterparties we would prefer not to be exposed to? This paper addresses this issue in the context of the 2007-2009 crisis by proposing three market-based measures (two are based on credit default swap spreads and the other one, on stock prices) for identifying too risky counterparties among big international financial entities. Our results show that market prices provide significant early warning signals of the fragility of distressed financial institutions and that the accuracy of the market-based indicators is much better than the traditional rating’ and is similar to market-based ratings’ provided by a rating agency. Volatility issues are addressed by means of a simple smoothing procedure.
Keywords: credit crisis, risk management, credit risk, counterparty risk, prediction, rating
JEL Classification: E58, G21
Suggested Citation: Suggested Citation