Credit Derivatives and the Default Risk of Large Complex Financial Institutions
Abstract (Via SSRN)
This paper addresses the impact of developments in the credit risk transfer market on the viability of a group of systemically important nancial institutions. We propose a bank default risk model, in the vein of the classic Merton-type, which utilizes a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the global credit environment. In the rst step, we establish the existence of signicant detrimental volatility spillovers from the CDS market to the banks’ equity prices, suggesting a credit shock propagation channel which results in serious deterioration of the valuation of banks’ assets. In the second step, we show that substantial capital injections are required to restore the stability of the banking system to an acceptable level after shocks to the CDX and iTraxx indices.