Abstract
We propose a multi-factor Gaussian model to analyze the dynamics of sovereign bond yields, as well as sovereign and banks CDS quotes. This paper has three objectives (all of them with relevant implications from a supervisory perspective): (1) disentangling the credit risk component of sovereign bonds from the interest rate component; (2) exploring the sovereign CDS-bond basis, i.e. the di□erence between sovereign CDS quotes and the corresponding bond yields; (3) inferring from CDS quotes the idiosyncratic component of a bank credit risk and analyzing its relation with sovereign risk. We cast the model in a state-space form with linear measurement function. To calibrate the model we consider a maximum likelihood estimation together with a Kalman □lter method in which both the gradient vector and the Hessian matrix to be used in the optimization can be computed in closed form.
Highlights
Even though there exists a vast amount of research on the static pricing of complex credit derivatives, such as first-to-default swaps or synthetic collateralized debt obligations (CDOs), there are only a few empirical studies that explore under a dynamic perspective the behavior of sovereign bonds, sovereign credit default swap (CDS), and domestic banks CDS during the last financial downturn
Bond prices and CDS spreads reflect, among other things, in addition to the market risk associated with the dynamics of interest rates, the default risk of the bond issuer and other risks associated with the markets in which these instruments are traded
We report for each bank the parameters calibrated on CDS spreads
Summary
Even though there exists a vast amount of research on the static pricing of complex credit derivatives, such as first-to-default swaps or synthetic collateralized debt obligations (CDOs), there are only a few empirical studies that explore under a dynamic perspective the behavior of sovereign bonds, sovereign credit default swap (CDS), and domestic banks CDS during the last financial downturn. An Empirical Analysis on Sovereigns and Banks form model calibrated on government bonds; (2) another component, to which we refer to as basis component, estimated by fitting the model on observed sovereign CDS spreads. Even if the information derived by the implied volatilities of these liquid derivatives may be considered to capture the market expectation on future rates, the analysis of these derivatives is beyond the scope of this paper These models are usually calibrated under a static perspective, that is, at each given point in time the model prices have to be as close as possible to the prices traded in the market and, even if the market is quoting unreasonable prices, the trader has to find the parameters that replicate those prices.
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