Modeling and Monitoring Risk Acceptability in Markets: The Case of the Credit Default Swap Market

35 Pages Posted: 26 Mar 2014

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Date Written: March 25, 2014

Abstract

Minimal discounted distorted expectations across a range of stress levels are employed to model risk acceptability in markets. Interactions between discounting and stress levels used in measure changes are accommodated by lowering discount rates for the higher stress levels. Acceptability parameters represent a maximal and minimal discount rate, a maximal stress level and the speed of rate reduction in response to stress. An explicit model relating credit default swap (CDS) prices to default probabilities is formulated with a view to making the default risk market acceptable. Data on CDS prices and default probabilities for the six major US banks obtained from the Risk Management Institute of the National University of Singapore is employed to estimate parameters defining acceptability and the movements in market implied recovery rates. We observe that the financial crisis saw an increase in the maximal discount rate and its spread over the minimal rate along with an increase in the maximal stress level being demanded for acceptability and a stable pattern for the speed of rate adjustment through the period. The maximal rate, rate spread and stress levels have come down but with periods in the interim where they have peaked as they did in the crisis. Recovery rates have oscillated and they did fall substantially but have recovered towards 40 percent near the end of the period.

Keywords: separating hyperplanes, measure changes, minmaxvar distortion, bid and ask prices.

JEL Classification: G10, G11 and G13.

Suggested Citation

Madan, Dilip B., Modeling and Monitoring Risk Acceptability in Markets: The Case of the Credit Default Swap Market (March 25, 2014). Robert H. Smith School Research Paper No. RHS 2414722, Available at SSRN: https://ssrn.com/abstract=2414722 or http://dx.doi.org/10.2139/ssrn.2414722

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

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