Disentangling the bond-CDS nexus: a stress test model of the CDS market
AbstractThis paper presents a stress test model for the CDS market, with a focus on the interplay between banks’ bond and CDS holdings. The model enables the analysis of credit risk transfer mechanisms, includes features of market and liquidity risk, and allows for contagious propagation of counterparty failures. As an illustration, we calibrate the model using sovereign bond and CDS data for 65 major European banks. The model simulation shows that, in case of a sovereign credit event, banks’ losses due to direct and correlated bond exposures are significantly higher than losses due to CDS exposures. The main risk for CDS sellers is found to be sudden increases in collateral requirements on multiple correlated CDS exposures. Close-out netting considerably reduces the extent to which contagion may occur. JEL Classification: G21, H63, G15
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Date of creation: Oct 2013
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Find related papers by JEL classification:
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-11-16 (All new papers)
- NEP-FMK-2013-11-16 (Financial Markets)
- NEP-RMG-2013-11-16 (Risk Management)
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