The relationship between credit default swap spreads and equity prices

Abstract

To meet new Basel III capital requirements, banks have to proxy unobserved credit default swap (CDS) time series for their over-the-counter derivative counterparties to determine the credit valuation adjustment (CVA) value-at-risk. This paper establishes a link between returns on CDSs and corresponding equity prices that allows CDS proxy series to be generated that retain important idiosyncratic risk, which is lost in more typical mapping methods. In so doing, the multifactor model developed shows a consistent pricing of credit risk in both the CDS market and the equity market. The model is intuitive, requires few assumptions and relies on readily available data. The model also performs well when compared with the CreditGrades model for proxy CDS spreads. Therefore, it tackles the modeling challenges set by Basel III for proxying single-name CDS spreads.