Credit risk

About: Credit risk is a research topic. Over the lifetime, 18595 publications have been published within this topic receiving 382866 citations.

Intermediation and voluntary exposure to counterparty risk

Abstract: I develop a model of the financial sector in which endogenous intermediation among debt financed banks generates excessive systemic risk. Financial institutions have incentives to capture intermediation spreads through strategic borrowing and lending decisions. By doing so, they tilt the division of surplus along an intermediation chain in their favor, while at the same time reducing aggregate surplus. I show that a core-periphery network – few highly interconnected and many sparsely connected banks – endogenously emerges in my model. The network is inefficient relative to a constrained efficient benchmark since banks who make risky investments "overconnect", exposing themselves to excessive counterparty risk, while banks who mainly provide funding end up with too few connections. The predictions of the model are consistent with empirical evidence in the literature.

Partial Differential Equation Representations of Derivatives with Bilateral Counterparty Risk and Funding Costs

Abstract: We derive a partial differential equation (PDE) representation for the value of financial derivatives with bilateral counterparty risk and funding costs. The model is very general in that the funding rate may be different for lending and borrowing and the mark-to-market value at default can be specified exogenously. The buying back of a party's own bonds is a key part of the delta hedging strategy; we discuss how the cash account of the replication strategy provides sufficient funds for this.First, we assume that the mark-to-market value at default is given by the total value of the derivative, which includes counterparty risk. We find that the resulting pricing PDE becomes non-linear, except in special cases, when the non-linear terms vanish and a Feynman-Kac representation of the total value can be obtained. In these cases, the total value of the derivative can be decomposed into the default-free value plus a bilateral credit valuation and funding adjustment.Second, we assume that the mark-to-market value at default is given by the counterparty-riskless value of the derivative. This time, the resulting PDE is linear and the corresponding Feynman-Kac representation is used to decompose the total value of the derivative into the default-free value plus bilateral credit valuation and funding cost adjustments.A numerical example shows that the effect on the valuation adjustments of a non-zero funding spread can be significant.The Addendum for this paper is available at the following URL: http://ssrn.com/abstract=2109723

Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets

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Using Transfer Entropy to Measure Information Flows Between Financial Markets

Abstract: We apply the concept of transfer entropy to quantify information flows between financial time series. Transfer entropy is a model-free measure designed as the Kullback-Leibler distance of transition probabilities. This approach allows to determine information transfer without being restricted to linear dynamics. We further develop a bootstrap procedure in order to allow for statistical inference of the estimates. In our empirical application, we examine the importance of the CDS and bond market for the process of pricing credit risk as well as the dynamic relation between market risk and credit risk proxied by the iTraxx Europe and the VIX.