This paper investigates how the market valuation of credit risk changed during 2008-2009 via a separation of the probability of default (PD) and the loss given default (LGD) of credit default swaps (CDSs), using the information implied by equity options. While the Lehman Brothers collapse in September 2008 harmed the stability of the financial systems in major industrialized countries, the CDS spreads of some major UK banks did not increase in response to this turmoil in financial markets including the decline in their own stock prices. This implies that the CDS spreads of financial institutions may not reflect all their credit risk due to the government interventions. Since CDS spreads are not appropriate to analyze the impact of the government interventions on credit risk and the cross sectional movement of credit risk, we investigate how the government interventions affect the PD and LGD of financial institutions and how the PD and LGD of financial institutions were related with those of non-financial firms. We demonstrate that the rise in the credit risk of financial institutions did not bring about that of non-financial firms (credit risk contagion) both in the US and UK using principal component analysis.
Keywords: Credit Default Swap (CDS); Probability of Default (PD); Loss Given Default (LGD); Credit Risk Contagion
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.