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A New Risk Indicator and Stress Testing tool; A Multifactor Nth-to-Default CDS Basket

  • Renzo G. Avesani
  • Jing Li
  • Antonio Garcia Pascual

This paper generalizes a market-based indicator for financial sector surveillance using a multifactor latent structure in the determination of the default probabilities of an nth-todefault credit default swap (CDS) basket of large complex financial institutions (LCFIs). To estimate the multifactor latent structure, we link the market risk (the covariance of the LCFIs' equity) to credit risk (the default probability of the CDS basket) in a coherent manner. In addition, to analyze the response of the probabilities of default to changing macroeconomic conditions, we run a stress test by generating shocks to the latent multifactor structure. The results unveil a rich set of default probability dynamics and help in identifying the most relevant sources of risk. We anticipate that this approach could be of value to financial supervisors and risk managers alike.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/105.

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Length: 25
Date of creation: 01 Apr 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/105
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  1. Christian Hawkesby & Ian W Marsh & Ibrahim Stevens, 2005. "Comovements in the prices of securities issued by large complex financial institutions," Bank of England working papers 256, Bank of England.
  2. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2002. "Equity and bond market signals as leading indicators of bank fragility," Working Paper Series 0150, European Central Bank.
  3. M. Hashem Pesaran & Til Schuermann & Bjorn-Jakob Treutler, 2007. "Global Business Cycles and Credit Risk," NBER Chapters, in: The Risks of Financial Institutions, pages 419-474 National Bureau of Economic Research, Inc.
  4. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson & David Schranz, 2005. "Measuring default risk premia from default swap rates and EDFs," BIS Working Papers 173, Bank for International Settlements.
  5. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.).
  6. Elsinger, Helmut & Lehar, Alfred & Summer, Martin, 2005. "Using Market Information for Banking System Risk Assessment," MPRA Paper 817, University Library of Munich, Germany.
  7. 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.
  8. Renzo G. Avesani, 2005. "First; A Market-Based Approach to Evaluate Financial System Risk and Stability," IMF Working Papers 05/232, International Monetary Fund.
  9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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