Disentangling the Bond-CDS Nexus: A Stress Test Model of the CDS Market
33 Pages Posted: 8 Nov 2013
Date Written: October 15, 2013
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: Suggested Citation