Default Contagion and Systemic Risk in the Presence of Credit Default Swaps
23 Pages Posted: 1 Feb 2017 Last revised: 31 Jan 2018
Date Written: January 31, 2018
We consider a clearing system of an interbank market in the case in which cross-trading of credit default swaps among banks is present, and we investigate the effect of credit default swaps on market stability. The existence and uniqueness of a clearing payment vector is proved under the assumption of the fictitious default algorithm with financial covenants, which reflects technical defaults often observed in actual financial markets. Some numerical results are presented to show that, in contrast to the previous literature, a complete network does not necessarily imply the most stable market when credit default swaps are introduced.
Keywords: credit default swap, default costs, cross-holding, clearing payment, default contagion, systemic risk
JEL Classification: G13, G32, G33, L14
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