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Derivatives and credit contagion in interconnected networks

  • S. Heise

    ()

  • R. Kühn

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.

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File URL: http://hdl.handle.net/10.1140/epjb/e2012-20740-0
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Article provided by Springer & EDP Sciences in its journal The European Physical Journal B.

Volume (Year): 85 (2012)
Issue (Month): 4 (April)
Pages: 1-19

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Handle: RePEc:spr:eurphb:v:85:y:2012:i:4:p:1-19
DOI: 10.1140/epjb/e2012-20740-0
Contact details of provider: Web page: http://www.springer.com

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  1. Sheri Markose & Simone Giansante & Mateusz Gatkowski & Ali Rais Shaghaghi, 2010. "Too Interconnected To Fail: Financial Contagion and Systemic Risk In Network Model of CDS and Other Credit Enhancement Obligations of US Banks," Working Papers 033, COMISEF.
  2. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
  3. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
  4. Helen Haworth & Christoph Reisinger & William Shaw, 2008. "Modelling bonds and credit default swaps using a structural model with contagion," Quantitative Finance, Taylor & Francis Journals, vol. 8(7), pages 669-680.
  5. Egloff, Daniel & Leippold, Markus & Vanini, Paolo, 2007. "A simple model of credit contagion," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2475-2492, August.
  6. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
  7. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409 World Scientific Publishing Co. Pte. Ltd..
  8. Neu, Peter & Kühn, Reimer, 2004. "Credit risk enhancement in a network of interdependent firms," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 342(3), pages 639-655.
  9. Damiano Brigo & Kyriakos Chourdakis, 2009. "Counterparty Risk For Credit Default Swaps: Impact Of Spread Volatility And Default Correlation," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 1007-1026.
  10. Darrell DUFFIE & Andreas ECKNER & Guillaume HOREL & Leandro SAITA, . "Frailty Correlated Default," Swiss Finance Institute Research Paper Series 08-44, Swiss Finance Institute.
  11. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers 383, Bank of England.
  12. J. P. L. Hatchett & R. Kuhn, 2009. "Credit contagion and credit risk," Quantitative Finance, Taylor & Francis Journals, vol. 9(4), pages 373-382.
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