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Liquidation equilibrium with seniority and hidden CDO

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  • Gourieroux, C.
  • Heam, J.C.
  • Monfort, A.

Abstract

The aim of our paper is to price credit derivatives written on a single name when this name is a bank. Indeed, due to the special structure of the balance sheet of a bank and to the interconnections with other institutions of the financial system, the standard pricing formulas do not apply and their use can imply severe mispricing. The pricing of credit derivatives written on a single bank name requires a joint analysis of the risks of all banks directly or indirectly interconnected with the bank of interest. Each name cannot be priced in isolation, but the banking system must be treated as a whole. It is necessary to analyze the contagion of losses among banks, especially the equilibrium of joint defaults and recovery rates at liquidation time. We show the existence and uniqueness of such an equilibrium. Then the standard pricing formulas are modified by adding a premium to capture the contagion effects.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 37 (2013)
Issue (Month): 12 ()
Pages: 5261-5274

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Handle: RePEc:eee:jbfina:v:37:y:2013:i:12:p:5261-5274

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Web page: http://www.elsevier.com/locate/jbf

Related research

Keywords: Collateralized debt obligation; Contagion; Solvency risk; Value-of-the firm model; Liquidation equilibrium; Contagion premium; Systemic risk;

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  1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  2. Degryse, H.A. & Nguyen, G., 2004. "Interbank Exposures: An Empirical Examination of Systemic Risk in the Belgian Banking System," Discussion Paper 2004-4, Tilburg University, Center for Economic Research.
  3. George Sheldon & Martin Maurer, 1998. "Interbank Lending and Systemic Risk: An Empirical Analysis for Switzerland," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 134(IV), pages 685-704, December.
  4. Upper, Christian & Worms, Andreas, 2004. "Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?," European Economic Review, Elsevier, vol. 48(4), pages 827-849, August.
  5. Gourieroux, C & Laffont, J J & Monfort, A, 1980. "Coherency Conditions in Simultaneous Linear Equation Models with Endogenous Switching Regimes," Econometrica, Econometric Society, vol. 48(3), pages 675-95, April.
  6. Gourieroux, C. & Heam, J.C. & Monfort, A., 2012. "Bilateral Exposures and Systemic Solvency Risk," Working papers 414, Banque de France.
  7. Gabrielle Demange, 2012. "Contagion in financial networks: a threat index," PSE Working Papers halshs-00662513, HAL.
  8. C. H. Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," BIS Working Papers 70, Bank for International Settlements.
  9. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
  10. Craig Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," Proceedings 633, Federal Reserve Bank of Chicago.
  11. repec:hal:wpaper:halshs-00662513 is not listed on IDEAS
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