Credit default swap spreads, fair-value spreads and interest rate dynamics

Abstract

This paper examines the empirical relationship between credit risk and interest rate risk. We use credit default swap (CDS) spreads as our measure of credit risk. Also, we control for the variation in the so-called fair-value spread that combines multiple sources of default risk, including the market price of risk, the loss given default and the expected default frequency. After taking into account the fair-value spread, the various proxies for the broad state of the macroeconomy and a liquidity risk factor, we find that the interest rate shock serves as a key determinant of CDS spread movements in most subsamples organized by industry type and credit rating status. Moreover, we find that the swap interest rate variables convey additional information about the CDS spread movements beyond the Treasury interest rate variables. These results have implications for the parameterization of baseline interest rate dynamics in the Monte Carlo simulation of economic capital for a given credit portfolio.