A New Risk Indicator and Stress Testing Tool: A Multifactor Nth-to-Default CDS Basket, Issues 2006-2105
International Monetary Fund, Apr 1, 2006 - Business & Economics - 25 pages
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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15 LCFIs ABN Amro average correlation based on CDS basket of CDSs BNP Paribas book runners Calculations are based CDS basket common factors complex financial institutions compute the probabilities conduct stress test correlation and factor correlation structure credit default swap credit spreads default correlations default increases Deutsche Bank estimated correlation factor analysis Factor Factor Factor factor in recession factor is related factor loadings factor model Figure financial shocks financial soundness indicators Following Hull Goldman Sachs historical distribution horizon HSBC Hull and White idiosyncratic implied probability institutions are positively investment banking Large Complex Financial latent factor structure Lehman Brothers likelihood macro-prudential analysis market-based indicator Merrill Lynch ML estimates Morgan Stanley multifactor representation multifactor structure percent percentile probabilities of default probability of observing probability of zero risk risk-neutral probabilities rotated spreads for end stress test analysis synthetic CDO three defaults two-year forward probability U.S. institutions underlying vector