Redesigning Credit Derivatives to Better Cover Sovereign Default Risk

Posted: 4 May 2012 Last revised: 6 Jul 2012

Darrell Duffie

Stanford University - Graduate School of Business; National Bureau of Economic Research (NBER)

Mohit Thukral

Stanford University

Date Written: May 3, 2012

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

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: https://ssrn.com/abstract=2050499 or http://dx.doi.org/10.2139/ssrn.2050499

James Darrell Duffie (Contact Author)

Stanford University - Graduate School of Business ( email )

655 Knight Way
Knight Management Center
Stanford, CA 94305-7298
United States
650-723-1976 (Phone)
650-725-8916 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Mohit Thukral

Stanford University ( email )

Stanford, CA 94305
United States

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