Interaction-Based Model for Pricing CDS with Counterparty Risk

Abstract

The paper provides methodologically new approach to pricing CDS, predicated on the banking network and the banks’ balance sheets. The model is evolutionary and includes a counterparty risk and the central bank bailout policy. The banking network is used to accurately calculate the capital ratio of each bank at each point in time, which serves as information to accurately calculate the bank’s probability of default and then its CDS price. Default events across the banks may be correlated due to similarities in banks’ balance sheet structures, the shock magnitude, the counterparty risk and the bailout policy. Interplay of these factors helps us explain co-movements in the CDS prices across the banks. Big and well capitalized small banks tend to have smaller median CDS prices than others. A credit event of a substantial magnitude may push the prices into the extreme in a very short period of time. Bailout policy of the central bank is significant in preventing contagion by which it indirectly affects CDS prices. It has been demonstrated that there is the interplay between the systemic and the bank-specific components in the shock effects. The shock exhibits an extreme nonlinear characteristic in the CDS prices.

Keywords: structural models, banking system, interaction-based finance, network models, CDS, credit risk, evolutionary models

JEL Classification: C63, G12