I have been using CreditGrades to calculate fair one year CDS spreads for firms. However, the authors of the model explicitly say that the model does not hold for banks or financial firms. If I need to price a thereotical one year CDS spread for a financial firm, what are some suggestions or starting points for an alternative model for accomplishing this? Could I potentially modify the assumptions of the CreditGrades model to hold for banks?

This is the creditgrades technical document: http://www.creditrisk.ru/publications/files_attached/cgtechdoc.pdf

  • $\begingroup$ Default risk for banks and financial institutions is usually assessed with complex stress-test scenarii. Because you need a complete understanding of the financial network and of the different exposures among banks, it is unlikely that such a model actually exists... but I may be wrong, at least I don't know of any model like that. $\endgroup$ – Louis. B Nov 24 '15 at 23:22
  • $\begingroup$ would typical structural models like the Merton model not hold or would they be inaccurate? $\endgroup$ – beeba Nov 25 '15 at 14:16
  • $\begingroup$ I think it would probably work in an economy with a single commercial bank, although it would be hard to evaluate the degree of riskiness of the assets of the banks. But banks use off-balance sheet contracts like derivatives that may be harder to price or even to have a comprehensive view of all the bank commitments. On top of that there are also some risks like liquidity risk, or contagion risk that may affect one bank because another one defaults. Banks are really different from other firms, and they require some specific (and complex) risk models. $\endgroup$ – Louis. B Nov 26 '15 at 16:59

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