Estimating the joint probability of default using Credit Default Swap and Bond Data

Systemic default risk—that is, the risk of the simultaneous default of multiple institutions—has caused great concern in the recent past. The aim of this article is to estimate the joint probability of default for multiple financial institutions. Both bond and credit derivative markets convey information on the default process: The former provides information on the marginal, the latter, on the joint default probabilities. We consider the corporate bond and the credit default swap (CDS) markets. The over-the-counter nature of the CDS market implies the presence of counterparty risk, or the risk that the protection seller will fail to fulfill its obligations. The counterparty risk is reflected in the CDS price through the joint default probability of the reference entity and the protection seller. Applying a no-arbitrage argument, we extract from market data forward-looking joint default probabilities of financial institutions operating in the CDS market from January 3, 2005–Mar 15, 2010.