Contagion Effect Among Financial Institutions And Sovereign Credit Default Swap Of Pakistan; State Dependent Sensitivity Analysis Value At Risk Ap

4087 words - 17 pages

1.Introduction:
In developing countries the major driver of economic growth are financial institutions, which are interlinked through innovation in response to the forces of globalization and technology. Rigorous risk management efforts are made to strengthen the financial bodies and economy.
The three possible channel of financial stress spread from one financial institution to the remainder of financial organization are: other party vulnerability, capital markets linkages, and investor confidence. Prices, nevertheless, specify an innate way of measuring the interconnection amongst institutions by all three-risk diffusion means (Monks & Stringa, 2005).
Commencing since the mid-1990s a ...view middle of the document...

Where as, individual investors normally uphold a portfolio for an extended time period say a month or longer. Therefore, this research engages one-day holding period, considering a somewhat dynamic portfolio managers’ stance.
Financial instruments like credit derivatives not only deals with risk but also involves the transfer of risk (systemic risk). The prime constituents of derivative market are corporates and sovereigns, where corporates entails 80% of this markets and the rest of 20% belongs to sovereign. The size of derivative market exceeds $26000 billion as per the credit default swap market report (2011).
After the Argentine turmoil, Asian financial crisis, the Russian bond default, and recent downgrading of Italian sovereign, serious attention is paid regarding the mitigation of sovereign risk. Emerging Credit Derivative Market, (EMCD) boom in late 1997. This market outperform in 1998 when Russian bond default. But the liquidity of this market depends on the depth and breath of repo and bond of the growing economies.
There fore, the main focus of the study is on contagion effect in financial sector, other than the involvement of financial bodies to systemic risk. Analyzing how the value –at- risk (VaR) of one set of financial institution is influenced by the value-at-risk (VaR) of remaining three sets of financial institutions and sovereign credit default swap. This study also explores the effect of various state of economy on the extent of contingent effect amongst the four major financial bodies (commercial banks, insurance companies, mutual funds and investment banks). How long this contagion effect persists. Our study is closely related to Adams et.al (2013) but we also study the impact of country risk. Therefore SCDS value at risk is calculated as per the valuation of swaps described by Raunig and Scheicher (2008).
Majority of the literature investigate systemic risk and risk spread outs in banks. The main studies assert that systemic risk propagating channels are; market sentiments (Hott, 2009; Shleifer & Vishny, 2009), the increase in credit risk transmission (Altunbas, Leonardo, & Marquez-Ibanez, 2010; Hakenes & Schnabel, 2010), and the lack of liquidity and high bankruptcy amongst banking sector (Diamond & Rajan, 2005). Gropp, Lo Duca, & Vesala, (2009), and Hartmann, Straetmans, & De Vries (2006) demonstrate that crises in one banking system diffuse to other country banking structures. Billio, Getmansky, Lo, & Pellizzon, (2010) study systemic risk indices, generated through Granger Causality tests and Principal Component analysis.
Contemporary findings also support risk contagion effect in insurance companies. Further Allan & Marco (2005) explore substantial progress in transmitting credit risk of various financial institutions ends in risk transferal from the banks to the insurance companies. Additionally, financial institutions that are extremely reliant on outside funding undergo the highest detrimental shock in crisis....

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