Modeling and monitoring risk acceptability in markets: The case of the credit default swap market |
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| Institution: | 1. The Wang Yanan Institute for Studies in Economics, Xiamen University, Fujian 361005, China;2. Department of Economics, Cornell University, Ithaca, NY 14853, USA;1. School of Accounting and Finance, Hong Kong Polytechnic University, Hunghom, Kowloon, Hong Kong;2. Department of Finance and Decision Sciences, Hong Kong Baptist University, Kowloon Tong, Kowloon, Hong Kong;3. Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong;1. International Monetary Fund, United States;2. DRM-Finance, Université Paris Dauphine, PSL Research University, Place du Maréchal de Lattre de Tassigny, 75016 Paris, France;1. Department of Economics, University of Sheffield, 9 Mappin Street, Sheffield S1 4DT, United Kingdom;2. Department of Quantitative Methods and Information Systems, Indian Institute of Management, Bangalore, India;1. Department of Finance and International Business, Fu Jen Catholic University, No. 510, Jhongjheng Rd., Sinjhuang Dist., New Taipei City 24205, Taiwan, ROC;2. Department of Finance, National Taiwan University, No. 1, Sec. 4, Roosevelt Rd., Taipei City 10617, Taiwan, ROC;1. Research and Business Development Department, Borsa Istanbul, Turkey;2. Zicklin School of Business, Baruch College, CUNY, United States |
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| Abstract: | Minimal discounted distorted expectations across a range of stress levels are employed to model risk acceptability in markets. Interactions between discounting and stress levels used in measure changes are accommodated by lowering discount rates for the higher stress levels. Acceptability parameters represent a maximal and minimal discount rate, a maximal stress level and the speed of rate reduction in response to stress. An explicit model relating credit default swap (CDS) prices to default probabilities is formulated with a view to making the default risk market acceptable. Data on CDS prices and default probabilities for the six major US banks obtained from the Risk Management Institute of the National University of Singapore is employed to estimate parameters defining acceptability and the movements in market implied recovery rates. We observe that the financial crisis saw an increase in the maximal discount rate and its spread over the minimal rate along with an increase in the maximal stress level being demanded for acceptability and a stable pattern for the speed of rate adjustment through the period. The maximal rate, rate spread and stress levels have come down but with periods in the interim where they have peaked as they did in the crisis. Recovery rates have oscillated and they did fall substantially but have recovered towards 40 percent near the end of the period. |
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| Keywords: | Separating hyperplanes Measure changes Minmaxvar distortion Bid and ask prices |
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