A New Risk Indicator and Stress Testing Tool : A Multifactor Nth-to-Default CDS Basket

Author/Editor:

Renzo G Avesani ; Jing Li ; Antonio Garcia Pascual

Publication Date:

April 1, 2006

Electronic Access:

Free Download. Use the free Adobe Acrobat Reader to view this PDF file

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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.

Series:

Working Paper No. 06/105

Subject:

English

Publication Date:

April 1, 2006

ISBN/ISSN:

9781451863659/1018-5941

Stock No:

WPIEA2006105

Format:

Paper

Pages:

25

Please address any questions about this title to publications@imf.org