Abstract
This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets.
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Notes
Suppose you have a holding of value 100 in a single representative risky asset with volatility of 25%. A portfolio of hedging instruments is constructed to reduce exposure to all but 5% of fluctuations of this risky asset. Should the terminal value of the risky asset drop by 20%, then the hedging instruments should provide an in-flow of 19, leaving a loss of 1. Let us now assume that the hedging portfolio provides a realized in-flow of 10 instead of the anticipated 19, the difference of 9 is the additional loss due to counterparty risk exposure.
The variance–covariance matrices over all the paths will be centered around \(\hat{\Sigma}\).
Source: HM Treasury Publications, December 2009, ‘Royal Bank of Scotland: details of Asset Protection Scheme and launch of the Asset Protection Agency’.
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Calice, G., Ioannidis, C. & Williams, J. Credit Derivatives and the Default Risk of Large Complex Financial Institutions. J Financ Serv Res 42, 85–107 (2012). https://doi.org/10.1007/s10693-011-0121-z
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DOI: https://doi.org/10.1007/s10693-011-0121-z