Credit Default Swap Spreads And Systemic Financial Risk

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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 (CDS) 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 the authors consider the entire set of CDS contracts written by each financial institution against the default of each other institution they can learn about all pairwise default probabilities across the financial network.