Credit Derivatives and the Default Risk of Large Complex Financial Institutions

65 Pages Posted: 21 Jul 2010 Last revised: 13 Feb 2011

Giovanni Calice

Loughborough University

Christos Ioannidis

University of Bath-Department of Economics

Julian M. Williams

Durham Business School

Multiple version iconThere are 4 versions of this paper

Date Written: 2009

Abstract

This paper addresses the impact of developments in the credit risk transfer market on the viability of a group of systemically important financial institutions. We propose a bank default risk model, in the vein of the classic Merton-type, which utilizes a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the global credit environment. In the first step, we establish the existence of significant detrimental volatility spillovers from the CDS market to the banks' equity prices, suggesting a credit shock propagation channel which results in serious deterioration of the valuation of banks' assets. In the second step, we show that substantial capital injections are required to restore the stability of the banking system to an acceptable level after shocks to the CDX and iTraxx indices. Our empirical evidence thus informs the relevant regulatory authorities on the magnitude of banking systemic risk jointly posed by CDS markets.

Keywords: distance to default, credit derivatives, credit default swap index, financial stability

JEL Classification: C32, G21, G33

Suggested Citation

Calice, Giovanni and Ioannidis, Christos and Williams, Julian M., Credit Derivatives and the Default Risk of Large Complex Financial Institutions (2009). Paolo Baffi Centre Research Paper No. 2009-75. Available at SSRN: https://ssrn.com/abstract=1645798 or http://dx.doi.org/10.2139/ssrn.1645798

Giovanni Calice (Contact Author)

Loughborough University ( email )

Ashby Road
Loughborough, LE11 3TU
Great Britain

Christos Ioannidis

University of Bath-Department of Economics ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

Julian M. Williams

Durham Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

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