Disentangling the bond-CDS nexus: A stress test model of the CDS market

- We present a stress test model of the CDS market.
- The model incorporates several features of the OTC market.
- The model is simulated using a unique dataset of European banks.
- The largest vulnerability is the inability to meet collateral calls.
- Collateralization and close-out netting significantly reduce contagion.

We present a stress test model for the CDS market, with a focus on the interplay between banks' bond and CDS holdings. The model enables us to analyse credit risk transfer mechanisms, features of market and liquidity risk, and features contagious propagation of counterparty failures. As an illustration, we calibrate the model using sovereign bond and CDS holdings data for 65 major European banks. The model simulation shows that, in case of a sovereign credit event, banks' losses due to direct and correlated bond exposures are significantly larger than losses due to CDS exposures. The main risk for CDS sellers is found to be sudden increases in collateral requirements on multiple correlated CDS exposures. Close-out netting considerably reduces the extent to which contagion may occur.