Disentangling the Bond-CDS Nexus: A Stress Test Model of the CDS Market

33 Pages Posted: 8 Nov 2013

See all articles by Guillaume Vuillemey

Guillaume Vuillemey

HEC Paris - Finance Department

Tuomas A. Peltonen

European Central Bank (ECB)

Date Written: October 15, 2013

Abstract

This 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.

Keywords: Credit event, Credit default swap, Contagion, Collateral, Market risk, Liquidity risk, Stress test

JEL Classification: G21, H63, G15

Suggested Citation

Vuillemey, Guillaume and Peltonen, Tuomas A., Disentangling the Bond-CDS Nexus: A Stress Test Model of the CDS Market (October 15, 2013). ECB Working Paper No. 1599, Available at SSRN: https://ssrn.com/abstract=2340380

Guillaume Vuillemey (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Libération
Paris, Not Applicable 78351
France
+33660204275 (Phone)

HOME PAGE: http://sites.google.com/site/guillaumevuillemey/home

Tuomas A. Peltonen

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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