Investor sentiment, debt solvency and the contagion of CDS counterparty liquidity crisis

In this paper, we construct a global game model considering the investor sentiment and the debt solvency of CDS counterparty, to discuss the contagion mechanism of a liquidity crisis among CDS counterparty. The paper finds: The contagion of a CDS counterparty liquidity crisis based on the investor expected default probability of reference asset, belief revision and behavior choice of investor on the debt solvency when reference asset’s credit-rating downgrade. Investors will decide whether to roll over their loans according to the expected default probability of reference asset and other type investors’ attitude to the default of reference asset. And the investors’ behavior will induce the liquidity problem of CDS seller. Investors could observe other type investors’ attitude to the default of reference asset and CDS seller, and decide whether to withdraw their deposits on the CDS buyer according to these signals. Furthermore, we analyzed the influencing mechanism which CDS spread, declaim rate and discount factor on the threshold of debt solvency which will induce the liquidity crisis in CDS buyer and the threshold of private signals which affect investors whether to roll over their deposits in CDS buyer. And we found that a positive correlation exists between discount factor and the contagion of CDS counterparty liquidity crisis, a negative correlation exists between declaim rate and the contagion of CDS counterparty liquidity crisis, and a positive correlation exists between CDS spread and the contagion of CDS counterparty liquidity crisis. This paper also provides the following policy implications: Standardizing the methods of credit rating, and improving the authority and accuracy of credit rating; considering the liquidity crisis of when pricing the CDS; buyer of CDS should continue strengthen post-loan supervision and increase the value of collateral duly; improving the risk distinguishing capacity of large creditors and guaranteeing the safety of financial markets.