A New Risk Indicator and Stress Testing Tool: A Multifactor Nth-to-Default CDS Basket

25 Pages Posted: 21 Jun 2006

See all articles by Renzo Avesani

Renzo Avesani

International Monetary Fund - Monetary and Financial Systems Department

Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: April 2006

Abstract

This paper generalizes a market-based indicator for financial sector surveillance using a multifactor latent structure in the determination of the default probabilities of an nth-to-default credit default swap (CDS) basket of large complex financial institutions (LCFIs). To estimate the multifactor latent structure, we link the market risk (the covariance of the LCFIs' equity) to credit risk (the default probability of the CDS basket) in a coherent manner. In addition, to analyze the response of the probabilities of default to changing macroeconomic conditions, we run a stress test by generating shocks to the latent multifactor structure. The results unveil a rich set of default probability dynamics and help in identifying the most relevant sources of risk. We anticipate that this approach could be of value to financial supervisors and risk managers alike.

Keywords: Risk management, market indicators, stress testing, credit default swap (CDS), collateralized debt obligation (CDO), credit risk, large complex financial institutions (LCFIs)

JEL Classification: G11, G13, G15, G21, G24

Suggested Citation

Avesani, Renzo and Garcia Pascual, Antonio I., A New Risk Indicator and Stress Testing Tool: A Multifactor Nth-to-Default CDS Basket (April 2006). IMF Working Paper No. 06/105, Available at SSRN: https://ssrn.com/abstract=910670

Renzo Avesani (Contact Author)

International Monetary Fund - Monetary and Financial Systems Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department ( email )

700 19th Street NW
Washington, DC 20431
United States

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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