Derivatives and Credit Contagion in Interconnected Networks

The importance of adequately modeling credit risk has once again been highlighted in the recent financial crisis. Defaults tend to cluster around times of economic stress due to poor macro-economic conditions, {\em but also} by directly triggering each other through contagion. Although credit default swaps have radically altered the dynamics of contagion for more than a decade, models quantifying their impact on systemic risk are still missing. Here, we examine contagion through credit default swaps in a stylized economic network of corporates and financial institutions. We analyse such a system using a stochastic setting, which allows us to exploit limit theorems to exactly solve the contagion dynamics for the entire system. Our analysis shows that, by creating additional contagion channels, CDS can actually lead to greater instability of the entire network in times of economic stress. This is particularly pronounced when CDS are used by banks to expand their loan books (arguing that CDS would offload the additional risks from their balance sheets). Thus, even with complete hedging through CDS, a significant loan book expansion can lead to considerably enhanced probabilities for the occurrence of very large losses and very high default rates in the system. Our approach adds a new dimension to research on credit contagion, and could feed into a rational underpinning of an improved regulatory framework for credit derivatives.Comment: 26 pages, 7 multi-part figure

Credit default swaps and financial stability

Credit default swaps (CDSs), initially intended as instruments for hedging and managing credit risk, have been pinpointed during the recent crisis as being detrimental to financial stability. We argue that the impact of credit default swap markets on financial stability crucially depends on clearing mechanisms and capital and liquidity requirements for large protection sellers. In particular, the culprits are not so much speculative or “naked” credit default swaps but inadequate risk management and supervision of protection sellers. When protection sellers are inadequately capitalised, OTC (over-the-counter) CDS markets may act as channels for contagion and systemic risk. On the other hand, a CDS market where all major dealers participate in a central clearing facility with adequate reserves can actually contribute to mitigating systemic risk. In the latter case, a key element is the risk management of the central counterparties, for which we outline some recommendations.

Credit default swaps and systemic risk

We present a network model for investigating the impact on systemic risk of central clearing of over the counter (OTC) credit default swaps (CDS). We model contingent cash flows resulting from CDS and other OTC derivatives by a multi-layered network with a core-periphery structure, which is flexible enough to reproduce the gross and net exposures as well as the heterogeneity of market shares of participating institutions. We analyze illiquidity cascades resulting from liquidity shocks and show that the contagion of illiquidity takes place along a sub-network constituted by links identified as ’critical receivables’. A key role is played by the long intermediation chains inherent to the structure of the OTC network, which may turn into chains of critical receivables. We calibrate our model to data representing net and gross OTC exposures of large dealer banks and use this model to investigate the impact of central clearing on network stability. We find that, when interest rate swaps are cleared, central clearing of credit default swaps through a well-capitalized CCP can reduce the probability and the magnitude of a systemic illiquidity spiral by reducing the length of the chains of critical receivables within the financial network. These benefits are reduced, however, if some large intermediaries are not included as clearing members

Modelling bonds and credit default swaps using a structural model with contagion

This paper develops a two-dimensional structural framework for valuing credit default swaps and corporate bonds in the presence of default contagion. Modelling the values of related firms as correlated geometric Brownian motions with exponential default barriers, analytical formulae are obtained for both credit default swap spreads and corporate bond yields. The credit dependence structure is influenced by both a longer-term correlation structure as well as by the possibility of default contagion. In this way, the model is able to generate a diverse range of shapes for the term structure of credit spreads using realistic values for input parameters

Modeling basket credit default swaps with default contagion

The specification of a realistic dependence structure is key to the pricing of multi-name credit derivatives. We value small kth-to-default CDS baskets in the presence of asset correlation and default contagion. Using a first-passage framework, firm values are modeled as correlated geometric Brownian motions with exponential default thresholds. Idiosyncratic links between companies are incorporated through a contagion mechanism whereby a default event leads to jumps in volatility at related entities. Our framework allows for default causality and is extremely flexible, enabling us to evaluate the spread impact of firm value correlations and credit contagion for symmetric and asymmetric baskets

The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling

This article presents a comprehensive framework for valuing financial instruments subject to credit risk and collateralization. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats to financial markets. Some well-known risky valuation models in the markets can be viewed as special cases of this framework. We introduce the concept of comvariance (or comrelation) into the area of credit risk modeling to capture the default relationship among three or more parties. Accounting for default correlations and comrelations becomes important, especially during the credit crisis. Moreover, we find that collateralization works well for financial instruments subject to bilateral credit risk, but fails for ones subject to multilateral credit risk