Cointegration analysis of hazard rates and CDSs: Applications to pairs trading strategy

Abstract

This study examines the cointegration relationship between multiple credit default swap (CDS) spreads by constructing the cointegrated hazard rate model, which assumes the structure of the vector error correction model (VECM) in the drift term of hazard rate processes. We merge the cointegration nature into the framework of arbitrage-free pricing and thereby derive the theoretical spread formula of multiple cointegrated CDSs. For the estimation of hazard rate dynamics, we develop a Bayesian statistical inference method combined with the numerical ordinary differential equation solver because the theoretical CDS spread cannot be expressed in closed form. In the empirical study of Japanese corporate CDSs, we find that the overall term structures of cointegrated CDSs can be explained by a simple two-dimensional VECM of cointegrated hazard rates. Furthermore, we study the pairs trading strategy of CDSs.