How Important is a Non‐Default Factor for CDS Valuation?

Abstract

Unlike previous research based on structural or reduced‐form models, we investigate the importance of a non‐default factor for credit default swap (CDS) valuation by conducting non‐parametric local linear regression analyses using corporate CDS data from 2002 to 2011. We find that a model with an additional non‐default factor significantly outperforms a model with only a default factor, both in‐sample and out‐of‐sample, particularly for low credit rating CDS spreads. This improvement is robust to both credit rating and maturity. Our findings support the idea that non‐default risk is priced in CDS spreads and help explain CDS valuation. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:1088–1101, 2015