CDS and Stress Testing

During the last weeks, we have introduced and discussed many new concepts and tools together.

We are now able to define credit risk in the right way, and to contextualize it in the so-called Basel Framework.

We know the main differences between Basel II and Basel III, and we are able to estimate the PD of a counterparty using different techniques.

We know how to read credit ratings, and how to compute the PD starting from equity prices, using models like Merton’s one.

We can compute Value-at-Risk and Expected Shortfall. We know their points of strength, but also their weaknesses.

In this last lecture I want to teach you something more. But before I do, I want to remind you that some preparation needs to be done before you start with the materials of this week. I kindly ask you to read the pages posted under lecture 6: “preparation for next week”.

From one side, we will see how we can quickly compute the PD of a counterparty starting from credit spreads, in particular we will use CDS spreads.
A CDS, or Credit Default Swap, is a special financial instrument, very popular in finance. At least until the last crisis…

From the other, we will introduce stress testing, a very important risk management activity for international banks.
Stress testing is a requirement of Basel III.

This lecture contains: