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For Canadian banks, the CDS market is very illiquid and inactively traded. I want to get an estimate for the spread for a one year CDS on the Bank of Montreal. I was going to estimate this using the CreditGrades model ( http://www.creditrisk.ru/publications/files_attached/cgtechdoc.pdf ).

However, they mention that some algorithms (debt per share) may not hold for financial firms. Can CreditGrades be adapted to work for financial firms? Does it even make sense to get a spread estimate in this way? My goal is to find the one year survival probability for BMO.

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The capital structure of financial firms, especially one like Bank of Montreal, is indeed quite unlike the simple debts-and-assets model of CreditGrades.

For context, the model is basically one that says there are some assets $A$ subject to a stochastic process, and a debt level $L$ (unknown at the present time). If ever $A<L$ the company defaults.

They provide some calibration techniques and so on to make all of this work.

In any case, the picture of assets, where their value but not character varies, is completely wrong for a bank. The debt also is in flux. Thus, the model is essentially worthless.

I personally would price CDS for a big bank almost any other way. My top consideration would be government bailout probability should they get in trouble. For BMo, I rate that probability quite close to 1.0.

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  • $\begingroup$ Ah that makes sense. I figured that they are extremely credit safe. However I'm also interested in ranking the Canadian banks relative to each other by default probability, however slight the differences may be. I backed out survival probabilities from quoted CDS spreads to do this for American and European banks, but I can't apply the same analysis to the Canadian banks. Do you have any suggestions for an alternative or comparable model? Thank you. $\endgroup$ – beeba Oct 16 '15 at 18:38
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(Although the question was asked long time ago it may be of help for others as well)

You may want to have a look at Nagel and Purnanandam (2015) Bank Risk Dynamics and Distance to Default (https://www.bundesbank.de/Redaktion/EN/Downloads/Bundesbank/Research_Centre/Conferences/2016/2016_06_10_eltville_08_paper_nagel.pdf?__blob=publicationFile)

The authors propose a modification of the Merton's model specifically for financial institutions

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