New Economics Papers
on Banking
Issue of 2012‒10‒27
24 papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. Mortgage companies and regulatory arbitrage By Yuliya Demyanyk; Elena Loutskina
  2. A Model of Shadow Banking By Nicola Gennaioli
  3. Optimal Preventive Bank Supervision Combining Random Audits and Continuous Intervention By Mohamed Belhaj; Nataliya Klimenko
  4. Business cycles and financial crises: the roles of credit supply and demand shocks By James M. Nason; Ellis W. Tallman
  5. Banking and Trading By Arnoud W.A. Boot; Lev Ratnovski
  6. Reexamining the Empirical Relation between Loan Risk and Collateral: The Role of the Economic Characteristics of Collateral By Berger, A.N.; Frame, W.S.; Ioannidou, V.
  7. Housing and Liquidity By Yu Zhu; Randall Wright; Chao He
  8. The Impact of the LCR on the Interbank Money Market By Bonner, C.; Eijffinger, S.C.W.
  9. Diversification of Geographic Risk in Retail Bank Networks: Evidence from Bank Expansion after the Riegle-Neal Act By Victor Aguirregabiria; Robert Clark; Hui Wang
  10. Markets connectivity and financial contagion By Ruggero GRILLI; Gabriele TEDESCHI; Mauro GALLEGATI
  11. Financial Risk Capacity By Saki Bigio
  12. Fiscal Policy, Banks and the Financial Crisis By In''t Veld, Jan; Kollmann, Robert; Ratto, Marco; Roeger, Werner
  13. Funding, Collateral and Hedging: uncovering the mechanics and the subtleties of funding valuation adjustments By Andrea Pallavicini; Daniele Perini; Damiano Brigo
  14. Cascading Failures in Bi-partite Graphs: Model for Systemic Risk Propagation By Xuqing Huang; Irena Vodenska; Shlomo Havlin; H. Eugene Stanley
  15. Credit Risk Contagion and the Global Financial Crisis By Azusa Takeyama; Nick Constantinou; Dmitri Vinogradov
  16. Credit vs. Payment Services: Financial Development and Economic Activity Revisited By Ricardo Bebczuk; Tamara Burdisso; Máximo Sangiácomo
  17. Estimation of the Marginal Expected Shortfall: The Mean when a Related Variable is Extreme By Cai, J.; Einmahl, J.H.J.; Haan, L.F.M. de; Zhou, C.
  18. A Markov Copula Model of Portfolio Credit Risk with Stochastic Intensities and Random Recoveries By Bielecki, T.R.; Cousin, A.; Crépey, S.; Herbertsson, Alexander
  19. Vive la Différence: Social Banks and Reciprocity in the Credit Market By Simon Cornée; Ariane Szafarz
  20. Measuring and Analysing Marginal Systemic Risk Contribution using CoVaR: A Copula Approach By Brice Hakwa; Manfred J\"ager-Ambro\.zewicz; Barbara R\"udiger
  21. Russian interbank networks: main characteristics and stability with respect to contagion By A. V. Leonidov; E. L. Rumyantsev
  22. The efficiency and integrity of payment card systems: industry views on the risks posed by data breaches By Julia S. Cheney; Robert M. Hunt; Katy Jacob; Richard D. Porter; Bruce J. Summers
  23. A Framework for Extracting the Probability of Default from Stock Option Prices By Azusa Takeyama; Nick Constantinou; Dmitri Vinogradov
  24. Counterparty Risk and Funding: The Four Wings of the TVA By St\'ephane Cr\'epey; R\'emi Gerboud; Zorana Grbac; Nathalie Ngor

  1. By: Yuliya Demyanyk; Elena Loutskina
    Abstract: Mortgage companies (MCs) originated about 60% of all mortgages before the 2007 crisis and continue to hold a 30% market share postcrisis. While financial regulations are strictly enforced for depository institutions (banks), they are weakly enforced for MCs even if they are subsidiaries of a bank holding company (BHC). This study documents that the resulting regulatory arbitrage creates incentives for BHCs to engage in risk shifting through their MC affiliates. We show that MCs are established to circumvent the capital requirements and to shield the parent BHCs from loan-related losses. BHCs run the risky mortgage business through their MC affiliates. As compared to bank affiliates of BHCs, the MC affiliates lent more to individuals with lower credit scores, lower incomes, and higher loan-to-income ratios. MC borrowers experienced higher rates of foreclosure and delinquency during the crisis. Our results imply that the regulation in place had the capacity to prevent the deterioration of lending standards widely blamed for the crisis. The inconsistent enforcement of regulation, though, eroded its effectiveness. Higher involvement of mortgage companies in subprime lending and securitization activity do not explain our results.
    Keywords: Banks and banking ; Mortgages ; Foreclosure ; Regulation ; Regulation
    Date: 2012
  2. By: Nicola Gennaioli (CREI-UPF, Barcelona)
    Abstract: We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry-ups when investors ignore tail risks.
    Date: 2012
  3. By: Mohamed Belhaj (Centrale Marseille (Aix-Marseille School of Economics), CNRS & EHESS); Nataliya Klimenko (Aix-Marseille Université, Greqam)
    Abstract: Early regulator interventions into problem banks are one of the key suggestions of Basel II. However, no guidance is given on their design. To fill this gap, we outline an incentive-based preventive supervision strategy that eliminates bad asset management in banks. Two supervision techniques are combined: continuous regulator intervention and random audits. Random audit technologies differ as to quality and cost. Our design ensures good management without excessive supervision costs, through a gradual adjustment of supervision effort to the bank's financial health. We also consider preventive supervision in a setting where audits can be delegated to an independent audit agency, showing how to induce agency compliance with regulatory instructions in the least costly way.
    Keywords: banking supervision, random audit, incentives, moral hazard, delegation.
    JEL: G21 G28
    Date: 2012–01
  4. By: James M. Nason; Ellis W. Tallman
    Abstract: This paper explores the hypothesis that the sources of economic and financial crises differ from non-crisis business cycle fluctuations. We employ Markov-switching Bayesian vector autoregressions (MS-BVARs) to gather evidence about the hypothesis on a long annual U.S. sample running from 1890 to 2010. The sample covers several episodes useful for understanding U.S. economic and financial history, which generate variation in the data that aids in identifying credit supply and demand shocks. We identify these shocks within MS-BVARs by tying credit supply and demand movements to inside money and its intertemporal price. The model space is limited to stochastic volatility (SV) in the errors of the MS-BVARs. Of the 15 MS-BVARs estimated, the data favor a MS-BVAR in which economic and financial crises and non-crisis business cycle regimes recur throughout the long annual sample. The best-fitting MS-BVAR also isolates SV regimes in which shocks to inside money dominate aggregate fluctuations.
    Keywords: Markov processes
    Date: 2012
  5. By: Arnoud W.A. Boot (University of Amsterdam); Lev Ratnovski (IMF)
    Abstract: We study the effects of a bank’s engagement in trading. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large numbers). Trading is transactions-based: scalable, short-term, capital constrained, and with the ability to generate risk from concentrated positions. When a bank engages in trading, it can use its 'spare' capital to profitably expand the scale of trading. However there are two inefficiencies. A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And a bank may use trading for risk-shifting. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepening of financial markets in recent decades leads trading in banks to become increasingly risky, so that problems in managing and regulating trading in banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking.
    Date: 2012–10–11
  6. By: Berger, A.N.; Frame, W.S.; Ioannidou, V. (Tilburg University, Center for Economic Research)
    Abstract: Abstract: This paper offers a possible explanation for the conflicting results in the literature concerning the empirical relation between collateral and loan risk. We posit that certain economic characteristics of collateral may be associated with the empirical dominance of different risk-collateral channels implied by economic theory, namely the “lender selection,†“borrower selection,†“risk-shifting,†and “loss mitigation†channels. Each of these four channels has different predictions regarding the empirical relations between collateral and loan risk. For our sample of commercial loans, we find that the “lender selection†channel appears to be especially important for outside collateral, the “risk-shifting†and “loss mitigation†channels are important for liquid collateral, and the “borrower selection†channel appears to hold weakly for nondivertible collateral. Our results suggest that the conflicting results in the extant riskcollateral literature may occur because different samples may be dominated by collateral with different economic characteristics.
    Keywords: Collateral;Asymmetric Information;Banks.
    JEL: G21 D82 G38
    Date: 2012
  7. By: Yu Zhu (Wisconsin); Randall Wright (U Wisconsin); Chao He (University of Wisconsin-Madison)
    Abstract: We study economies where houses, in addition to providing utility as shelter, may also facilitate credit transactions, since home equity can be used as collateral. We document there were big increases in home-equity-backed consumption loans coinciding with the start of the house price boom, and suggest an explanation. When it can be used as collateral, housing can bear a liquidity premium. Since liquidity is endogenous, even when fundamentals are constant and agents fully rational house prices can display complicated equilibrium paths resembling bubbles. Our framework is tractable, with exogenous or with endogenous supply, yet captures several salient features of housing markets. The effects of monetary policy are also discussed.
    Date: 2012
  8. By: Bonner, C.; Eijffinger, S.C.W. (Tilburg University, Center for Economic Research)
    Abstract: Abstract: This paper analyses the impact of the Basel 3 Liquidity Coverage Ratio (LCR) on the unsecured interbank money market and therefore on the implementation of monetary policy. Combining two unique datasets, we show that banks which are just above/below their short-term regulatory liquidity requirement pay and charge higher interest rates for unsecured interbank loans. The effect is larger for longer maturities and increases after the failure of Lehman Brothers. During a crisis, being close to the minimum liquidity requirement induces banks to decrease lending volumes. Given the high importance of a well-functioning interbank money market, our results suggest that the current design of the LCR is likely to dampen the effectiveness of monetary policy.
    Keywords: Monetary Policy;Interbank Market;Basel 3.
    JEL: G21 E42 E43
    Date: 2012
  9. By: Victor Aguirregabiria; Robert Clark; Hui Wang
    Abstract: The 1994 Riegle Neal (RN) Act removed interstate banking restrictions in the US. The primary motivation was to permit geographic risk diversification (GRD). Using a factor model to measure banks' geographic risk, we show that RN expanded GRD possibilities in small states, but that few banks took advantage. Using our measure of geographic risk and a revealed preference approach, we identify preferences towards GRD separately from the contribution of other factors to branch network configuration. Risk has a negative effect on bank value, but this has been counterbalanced by economies of density/scale, reallocation/merging costs, and concerns for local market power.
    Keywords: Geographic risk diversification; Retail banking; Oligopoly competition; Branch networks; Riegle Neal Act
    JEL: L13 L51 G21
    Date: 2012–10–15
  10. By: Ruggero GRILLI (Universit… Politecnica delle Marche, Dipartimento di Scienze Economiche e Sociali); Gabriele TEDESCHI (Universit… Politecnica delle Marche, Dipartimento di Scienze Economiche e Sociali); Mauro GALLEGATI (Universit… Politecnica delle Marche, Dipartimento di Scienze Economiche e Sociali)
    Abstract: In this paper we investigate the sources of instability in credit and financial systems and the effect of credit linkages on the macroeconomic activity. By developing an agent-based model, we analyze the evolving dynamics of the economy as a complex, adaptive and interactive system, which allows us to explain some key elements occurred during the recent economic and financial crisis. In particular, we study the repercussions of inter-bank connectivity on agents' performances, bankruptcy waves and business cycle fluctuations. Interbank linkages, in fact, let participants share risk but also creates a potential for one bank's crisis to spread through the network. The purpose of the model is, therefore, to build up the dependence among agents at the micro-level and to estimate their impact on the macro stability.
    Keywords: Systemic risk, business cycle, giant component, network connectivity, volatility
    Date: 2012–10
  11. By: Saki Bigio (New York University)
    Abstract: Financial crises appear to persist if banks fail to be recapitalized quickly after large losses. I explain this impediment through a model where banks provide intermediation services in asset markets with informational asymmetries. Intermediation is risky because banks take positions over assets under disadvantageous information. Large losses reduce bank net worth and, therefore, the capacity to bear further losses. Losing this capacity leads to reductions in intermediation volumes that exacerbate adverse selection. Adverse selection, in turn, lowers bank prots which explains the failure to attract new equity. These financial crises are characterized by a depression in economic growth that is overcome only as banks slowly strengthen by retaining earnings. The model is calibrated and used to analyze several policy interventions.
    Date: 2012
  12. By: In''t Veld, Jan; Kollmann, Robert; Ratto, Marco; Roeger, Werner
    Abstract: This paper studies the effectiveness of Euro Area (EA) fiscal policy, during the recent financial crisis, using an estimated New Keynesian model with a bank. A key dimension of policy in the crisis was massive government support for banks—that dimension has so far received little attention in the macro literature. We use the estimated model to analyze the effects of bank asset losses, of government support for banks, and other fiscal stimulus measures, in the EA. Our results suggest that support for banks had a stabilizing effect on EA output, consumption and investment. Increased government purchases helped to stabilize output, but crowded out consumption. Higher transfers to households had a positive impact on private consumption, but a negligible effect on output and investment. Banking shocks and increased government spending explain half of the rise in the public debt/GDP ratio since the onset of the crisis.
    Keywords: bank rescue measures; financial crisis; fiscal policy
    JEL: E32 E62 F41 G21 H63
    Date: 2012–10
  13. By: Andrea Pallavicini; Daniele Perini; Damiano Brigo
    Abstract: The main result of this paper is a bilateral collateralized counterparty valuation adjusted pricing equation, which allows to price a deal while taking into account credit and debt valuation adjustments (CVA, DVA) along with margining and funding costs, all in a consistent way. We find that the equation has a recursive form, making the introduction of a purely additive funding valuation adjustment (FVA) difficult. Yet, we can cast the pricing equation into a set of iterative relationships which can be solved by means of standard least-square Monte Carlo techniques. As a consequence, we find that identifying funding costs FVA and debit valuation adjustments DVA is not tenable in general, contrary to what has been suggested in the literature in simple cases. We define a comprehensive framework that allows us to derive earlier results on funding or counterparty risk as a special case, although our framework is more than the sum of such special cases. We derive the general pricing equation by resorting to a risk-neutral approach. We consider realistic settings and include in our models the common market practices suggested by ISDA documentation, without assuming restrictive constraints on margining procedures and close-out netting rules. In particular, we allow for asymmetric collateral and funding rates, and exogenous liquidity policies and hedging strategies. Re-hypothecation liquidity risk and close-out amount evaluation issues are also covered. Finally, relevant examples of non-trivial settings illustrate how to derive known facts about discounting curves from a robust general framework and without resorting to ad hoc hypotheses.
    Date: 2012–10
  14. By: Xuqing Huang; Irena Vodenska; Shlomo Havlin; H. Eugene Stanley
    Abstract: In order to design complex networks that are robust and sustainable, we must understand systemic risk. As economic systems become increasingly interconnected, for example, a shock in a single financial network can provoke cascading failures throughout the system. The widespread effects of the current EU debt crisis and the 2008 world financial crisis occur because financial systems are characterized by complex relations that allow a local crisis to spread dramatically. We study US commercial bank balance sheet data and design a bi-partite banking network composed of (i) banks and (ii) bank assets. We propose a cascading failure model to simulate the crisis spreading process in a bi-partite banking network. We test our model using 2007 data to analyze failed banks. We find that, within realistic parameters, our model identifies a significant portion of the actual failed banks from the FDIC failed bank database from 2008 to 2011.
    Date: 2012–10
  15. By: Azusa Takeyama (Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:; Nick Constantinou (Lectuer, Essex Business School, University of Essex (E-mail:; Dmitri Vinogradov (Lectuer, Essex Business School, University of Essex (
    Abstract: This paper investigates how the market valuation of credit risk changed during 2008-2009 via a separation of the probability of default (PD) and the loss given default (LGD) of credit default swaps ( CDSs), using the information implied by equity options. While the Lehman Brothers collapse in September 2008 harmed the stability of the financial systems in major industrialized countries, the CDS spreads of some major UK banks did not increase in response to this turmoil in financial markets including the decline in their own stock prices. This implies that the CDS spreads of financial institutions may not reflect all their credit risk due to the government interventions. Since CDS spreads are not appropriate to analyze the impact of the government interventions on credit risk and the cross sectional movement of credit risk, we investigate how the government interventions affect the PD and LGD of financial institutions and how the PD and LGD of financial institutions were related with those of non-financial firms. We demonstrate that the rise in the credit risk of financial institutions did not bring about that of non-financial firms (credit risk contagion) both in the US and UK using principal component analysis.
    Keywords: Credit Default Swap (CDS), Probability of Default (PD), Loss Given Default (LGD), Credit Risk Contagion
    JEL: C12 C53 G13
    Date: 2012–10
  16. By: Ricardo Bebczuk (Universidad de La Plata, University of Illinois); Tamara Burdisso (Central Bank of Argentina); Máximo Sangiácomo (Central Bank of Argentina)
    Abstract: The purpose of this paper is to assess whether the banking system, over and beyond its credit function, has a significant impact on per capita GDP by providing means of payment. An annual database of 85 countries spanning the 1980-2008 period is exploited to this end. On the descriptive front, we find that richer economies exhibit higher and increasing levels of demand deposits and lower levels of currency than poor countries. While this was to be expected, more surprising is the fact that the currency to GDP ratio did not decrease much over time, regardless of income level differences. In turn, our regressions confidently support the hypothesis that banks contribute to economic development not only as credit suppliers but also by facilitating transactions. Specifically, along with the ratio of private credit to GDP, the ratio of demand deposits to currency seems to exert a positive influence on per capita GDP. The results are robust for different model specifications. These findings have valuable implications for a better understanding of the channels through which the banking system affects the economy.
    Keywords: banking system, credit, growth, means of payment
    JEL: C33 G20 O40
    Date: 2012–07
  17. By: Cai, J.; Einmahl, J.H.J.; Haan, L.F.M. de; Zhou, C. (Tilburg University, Center for Economic Research)
    Abstract: Abstract: Denote the loss return on the equity of a financial institution as X and that of the entire market as Y . For a given very small value of p > 0, the marginal expected shortfall (MES) is defined as E(X | Y > QY (1−p)), where QY (1−p) is the (1−p)-th quantile of the distribution of Y . The MES is an important factor when measuring the systemic risk of financial institutions. For a wide nonparametric class of bivariate distributions, we construct an estimator of the MES and establish the asymptotic normality of the estimator when p ↓ 0, as the sample size n → ∞. Since we are in particular interested in the case p = O(1=n), we use extreme value techniques for deriving the estimator and its asymptotic behavior. The finite sample performance of the estimator and the adequacy of the limit theorem are shown in a detailed simulation study. We also apply our method to estimate the MES of three large U.S. investment banks.
    Keywords: Asymptotic normality;extreme values;tail dependence.
    JEL: C13 C14
    Date: 2012
  18. By: Bielecki, T.R. (Illinois Institute of Technology); Cousin, A. (Université de Lyon); Crépey, S. (Université d’Évry Val d’Essonne); Herbertsson, Alexander (Department of Economics, School of Business, Economics and Law, Göteborg University)
    Abstract: In [4], the authors introduced a Markov copula model of portfolio credit risk. This model solves the top-down versus bottom-up puzzle in achieving efficient joint calibration to single-name CDS and to multi-name CDO tranches data. In [4], we studied a general model, that allows for stochastic default intensities and for random recoveries, and we conducted empirical study of our model using both deterministic and stochastic default intensities, as well as deterministic and random recoveries only. Since, in case of some “badly behaved” data sets a satisfactory calibration accuracy can only be achieved through the use of random recoveries, and, since for important applications, such as CVA computations for credit derivatives, the use of stochastic intensities is advocated by practitioners, efficient implementation of our model that would account for these two issues is very important. However, the details behind the implementation of the loss distribution in the case with random recoveries were not provided in [4]. Neither were the details on the stochastic default intensities given there. This paper is thus a complement to [4], with a focus on a detailed description of the methodology that we used so to implement these two model features: random recoveries and stochastic intensities.<p>
    Keywords: Portfolio Credit Risk; Markov Copula Model; Common Shocks; Stochastic Spreads; Random Recoveries
    JEL: C02 C63 G13 G32 G33
    Date: 2012–10–16
  19. By: Simon Cornée; Ariane Szafarz
    Abstract: Social banks are financial intermediaries paying attention to non-economic (i.e. social, ethical, and environmental) criteria. This paper investigates the behavior of social banks in the European credit market. We use a unique hand-collected dataset on 389 business loans granted by a French social bank. Our results show that the social bank charges below-market interest rates for viable social projects. Moreover, regardless of their creditworthiness, motivated borrowers respond to advantageous credit conditions by significantly lowering their probability of default. We interpret this outcome as the first evidence of reciprocity in the credit market.
    Keywords: Social bank; subsidized loan; social enterprise; ethical bank; start-up
    JEL: G21 D63 G24 H25
    Date: 2012–10–15
  20. By: Brice Hakwa; Manfred J\"ager-Ambro\.zewicz; Barbara R\"udiger
    Abstract: This paper is devoted to the quantification and analysis of marginal risk contribution of a given single financial institution i to the risk of a financial system s. Our work expands on the CoVaR concept proposed by Adrian and Brunnermeier as a tool for the measurement of marginal systemic risk contribution. We first give a mathematical definition of CoVaR_{\alpha}^{s|L^i=l}. Our definition improves the CoVaR concept by expressing CoVaR_{\alpha}^{s|L^i=l} as a function of a state l and of a given probability level \alpha relative to i and s respectively. Based on Copula theory we connect CoVaR_{\alpha}^{s|L^i=l} to the partial derivatives of Copula through their probabilistic interpretation and definitions (Conditional Probability). Using this we provide a closed formula for the calculation of CoVaR_{\alpha}^{s|L^i=l} for a large class of (marginal) distributions and dependence structures (linear and non-linear). Our formula allows a better analysis of systemic risk using CoVaR in the sense that it allows to define CoVaR_{\alpha}^{s|L^i=l} depending on the marginal distributions of the losses of i and s respectively and the copula between L^i and L^s. We discuss the implications of this in the context of the quantification and analysis of systemic risk contributions. %some mathematical This makes possible the For example we will analyse the marginal effects of L^i, L^s and C of the risk contribution of i.
    Date: 2012–10
  21. By: A. V. Leonidov; E. L. Rumyantsev
    Abstract: Systemic risks characterizing the Russian overnight interbank market from the network point of view are analyzed.
    Date: 2012–10
  22. By: Julia S. Cheney; Robert M. Hunt; Katy Jacob; Richard D. Porter; Bruce J. Summers
    Abstract: Consumer confidence in payment card systems has been built up over many decades. Cardholders expect to use their cards to execute payment instructions in a reliable and timely manner. Data breaches that degrade the perceived safety and reliability of payment cards may weaken consumer confidence in those systems and potentially cause cardholders to shift to other, and perhaps less efficient, forms of payment. A sizable shift away from payment cards —induced by the consequences of one or more data breaches is unlikely. Even so, the probability of such an outcome is uncertain. In other words, this could be an example of “tail risk” for payment card systems. The authors informally interviewed a number of market participants and several experts to better understand the risks presented by data breaches, the efforts to protect payment card systems against data breaches, and areas where more might be done to secure these systems. In particular, the authors investigated whether existing levels of investment, coordination, information sharing, and management of incentives in securing payment card systems by firms and organizations in the private and public sectors are adequate to confront the threats arising from modern data breaches. The lessons learned from these conversations are described in this paper. These insights may also be helpful in considering the risks that data breaches may broadly pose to retail payments in the United States.
    Keywords: Payment systems ; Fraud ; Data protection ; Credit cards ; Debit cards
    Date: 2012
  23. By: Azusa Takeyama (Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:; Nick Constantinou (Lectuer, Essex Business School, University of Essex (E-mail:; Dmitri Vinogradov (Lectuer, Essex Business School, University of Essex (
    Abstract: This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of a jump diffusion process, in which the underlying stock price jumps to zero at default. We adopt a two-stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. Since the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.
    Keywords: probability of default (PD), option pricing under credit risk, perturbation method
    JEL: C12 C53 G13
    Date: 2012–10
  24. By: St\'ephane Cr\'epey; R\'emi Gerboud; Zorana Grbac; Nathalie Ngor
    Abstract: The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely the counterparty risk. The related Credit Valuation Adjustment, (CVA), Debt Valuation Adjustment (DVA), Liquidity Valuation Adjustment (LVA) and Replacement Cost (RC) issues, jointly referred to in this paper as Total Valuation Adjustment (TVA), have been thoroughly investigated in the theoretical papers [Cr12a] and [Cr12b]. The present work provides an executive summary and numerical companion to these papers, through which the TVA pricing problem can be reduced to Markovian pre-default TVA BSDEs. The first step consists in the counterparty clean valuation of a portfolio of contracts, which is the valuation in a hypothetical situation where the two parties would be risk-free and funded at a risk-free rate. In the second step, the TVA is obtained as the value of an option on the counterparty clean value process called Contingent Credit Default Swap (CCDS). Numerical results are presented for interest rate swaps in the Vasicek, as well as in the inverse Gaussian Hull-White short rate model, also allowing one to assess the related model risk issue.
    Date: 2012–10

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