Derivatives and Credit Contagion in Interconnected Networks

TL;DR

This paper models credit default swap contagion in interconnected financial networks, revealing that CDS can increase systemic instability during economic stress, especially when used for loan expansion, challenging the notion of their risk-mitigating role.

Contribution

It introduces an exact stochastic model of credit default swap contagion in a stylized network, highlighting how CDS can amplify systemic risk under certain conditions.

Findings

CDS create additional contagion channels increasing systemic risk.

Loan book expansion with CDS can lead to higher default probabilities.

Systemic instability is heightened during economic stress when CDS are used for risk offloading.

Abstract

The importance of adequately modeling credit risk has once again been highlighted in the recent financial crisis. Defaults tend to cluster around times of economic stress due to poor macro-economic conditions, {\em but also} by directly triggering each other through contagion. Although credit default swaps have radically altered the dynamics of contagion for more than a decade, models quantifying their impact on systemic risk are still missing. Here, we examine contagion through credit default swaps in a stylized economic network of corporates and financial institutions. We analyse such a system using a stochastic setting, which allows us to exploit limit theorems to exactly solve the contagion dynamics for the entire system. Our analysis shows that, by creating additional contagion channels, CDS can actually lead to greater instability of the entire network in times of economic stress. This is particularly pronounced when CDS are used by banks to expand their loan books (arguing that CDS would offload the additional risks from their balance sheets). Thus, even with complete hedging through CDS, a significant loan book expansion can lead to considerably enhanced probabilities for the occurrence of very large losses and very high default rates in the system. Our approach adds a new dimension to research on credit contagion, and could feed into a rational underpinning of an improved regulatory framework for credit derivatives.