[Excerpt] Macro financial risk propagation and its implications on financial stability have emerged as major concerns of governments and financial institutions, particularly those with large financial asset pools. The global financial crisis in 2008–2009 was essentially centered on credit risk involving money markets, and the propagation of such risk across and among financial institutions and sovereigns is related to how connected they are.
To understand the concept of connectedness, Merton provides a brief review of the concepts of credit, credit risk, and guarantees. He asserts that risk- free credit is essentially risky credit coupled with a guarantee of payment in the event of a default. That is, risky debt is nothing but risk-free debt less a guarantee of repayment. We note that in complete contingent markets, the holder of debt always has the option to purchase insurance on the debt, pretty much like the credit default swaps that are available in advanced financial markets today. The guarantee could be issued by a financial institution or a sovereign government, and effectively transfers the risk of default from the borrower to the guarantor. From the perspective of the lending institution, however, the instrument or asset it is holding is now essentially risk-free debt. Merton stresses that the guarantees attached to risky debt are in fact insurance on the risk of default, and are akin to put options on assets of borrowers, with maturities similar to those of the debt instrument being guaranteed and a strike price equivalent to the promised payment of debt.