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Explaining Credit Default Swaps Pricing for Large Banks

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Abstract

The credit default swap spread appears to be a potent predictor of financial distress, however, its determinants have not yet been fully understood. This paper suggests a banking-industry-specific approach to the pricing of banks’ credit risk. It shows that the pricing of banks’ credit default swap spreads could be approximated by a risk frontier derived from portfolio theory, where banks are viewed as leveraged portfolios. The commonly applied structural credit risk model adds very little to the explanatory power of the portfolio based approach, thereby underlying the importance of the new approach to banks’ credit risk.

Suggested Citation

  • Otker-Robe, Inci & Podpiera, Jiri, 2012. "Explaining Credit Default Swaps Pricing for Large Banks," Journal of Financial Transformation, Capco Institute, vol. 34, pages 63-75.
  • Handle: RePEc:ris:jofitr:1515
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    Keywords

    Credit default swaps; large complex financial institutions; CDS spread; distress; credit risk;

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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