This paper presents a novel method to measure the joint default risk of large financial institutions (systemic default risk) using information in bond and credit default swap prices. Bond prices reflect individual default probabilities of the issuers. CDS contracts, which insure against such defaults, pay off only as long as the seller of protection itself is solvent. Therefore, CDS prices contain information about the probability of joint default of both the bond issuer and the protection seller. If we consider the prices of CDSs written by financial institutions against each other, together with bond prices, we can learn about all pairwise default probabilities across the financial network. However, this information set does not fully characterize the joint default risk of multiple institutions. In this paper, I show how to construct the tightest bounds on the probability
of systemic default events given this information set. Using this methodology I track the evolution of joint default risk of large banks during the financial crisis. I show that an increase in systemic default risk did not occur until after Bear Stearns’ collapse in March 2008, and that some of the observed spikes in bond and CDS spreads correspond to spikes in idiosyncratic risk rather than systemic risk.

Please note that the seminar is on Thursday and not on Tuesday as usual. Also the seminar room is different.