Pricing of Debt and Equity in a Financial Network with Comonotonic Endowments

Abstract

Valuing Debt and Equity in Interbank Networks Valuation adjustments to account for, for example, counterparty risk, have become an important part of derivative valuation by any bank since the 2007–2009 financial crisis. As evidenced by that crisis, considering the risk of a single firm alone can cause gross misspecification of firm health. In “Pricing of Debt and Equity in a Financial Network with Comonotonic Endowments,” Banerjee and Feinstein construct an analytical formulation for a valuation adjustment that takes the entire network of counterparty obligations into account when all institutions have comonotonic endowments. From the perspective of stress testing, such a setting corresponds to a systematic shock to all firms. This comonotonic setting is then shown to provide computationally tractable upper and lower bounds to the general network valuation problem. The authors demonstrate that the comonotonic endowment setting arises endogenously in a system of equity maximizing firms.