Research on Credit Default Swaps Pricing Considering Moral Hazard Incentive under Reduce-Form Model

Abstract

Equilibrium pricing of credit default swaps (CDS) promotes efficient identification of credit risk in the market, which in turn leads to efficient allocation of resources. However, even when CDS have been priced in equilibrium, i.e., when premiums are equal to anticipated payments, the moral hazard incentives of CDS buyers increase with CDS transactions. Consequentially, it becomes an interesting research direction to study the impact of moral hazard incentives on the trading mechanism or pricing of derivatives (CDS). Most of the existing literature on the impact of moral hazard incentives in CDS pricing on derivatives trading mechanisms takes a macro perspective and focuses on the agreement risk effect. The literature exploring the analysis of the impact of moral hazard on the probability of agreement default from a micro perspective is not yet available. With this in mind, this paper focuses on the mechanisms by which “fraud”, an extreme manifestation of micro-moral hazard incentives, affects the probability of default. This paper introduces for the first time the concept of “claiming fraud” by credit protection buyers, which is different from the macro perspective of moral hazard incentives, and thus defines a specific extreme form of moral hazard incentives. Meanwhile, to address the intrinsic feature of the lack of economic explanatory power of the reduce-form model, this paper introduces a moral hazard incentive factor into the reduce-form model, and proposes a moral hazard state variable as a function of the asset value of the reference entity, which gives the reduce-form model strong economic explanatory power, and the default predictability is reduced by the description of the reduce-form model. In terms of the object of study, this paper considers the issue of moral hazard incentives in the presence of claiming fraud in two reference entities to further explore the impact of moral hazard incentives on default protection at the micro level in terms of cyclic default. Finally, based on the analysis of the results of the numerical simulation experiments, it is proposed that increasing the number of reference assets for CDS buyers will help to reduce the moral hazard incentives of the buyer, and thus the anticipated payments to the buyer, i.e., we attempt to endogenize the credit risk of an asset by allowing the asset holder to choose the probability of the asset going up or down, which helps to understand the phenomenon of moral hazard incentives in CDS trading.

Keywords

Financial engineering / moral hazard incentive / claiming fraud / reduce-form model / probability of default calculation / CDS pricing

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