Contagion and Risk in the Amplification of Crisis: Evidence from Asian Names in the CDS Market

In the turmoil of 20072009, troubles in a relatively small corner of the US mortgage market escalated into a crisis of global proportions. An amplification mechanism were the huge valuation losses on credit instruments, which dwarfed actual losses from default. We argue that these valuation losses were driven not so much by a reassessment of risks as by a global repricing of these risks. For empirical evidence, we analyze fluctuations in credit default swap (CDS) spreads and expected default frequencies (EDFs) for major Asian borrowers. Because EDFs are estimated to exploit the forward-looking nature of stock prices, their use allows us to account for knock-on effects from the slowing economy on default risk. We find that valuation losses on CDS contracts for these borrowers arose in large part from movements in global and regional risk pricing factors rather than from revisions in individual expected losses from default alone.