CDS Prices Research Articles

How does standardization affect OTC markets in the long term? Evidence from the small bang reform in the CDS market

Focusing on the most liquid segment of the European CDS market, this paper studies the impact of a key standardization reform, known as the CDS Small Bang. We document that the reform provided unexpected long-term consequences. Particularly, we show that the introduction of an upfront fee to standardize the cash flow of CDS contracts created an initial capital cost for traders, which acts as a friction that increases CDS prices. This relation holds after accounting for well-known determinants of spreads, suggesting a separate funding channel driven by the greater capital intensity of trading. This effect grows in magnitude for several years following the implementation of the reform, becomes stronger when dealers are likely to bear the initial capital cost and is present across all industries, except for swaps written on financials shortly after the reform was introduced.

Pricing of Basket CDS with Bilateral Default Risk under Vasicek Model with Circular Contagion

In this study, on the basis of basket CDS, we take into account the complex correlations among market participants and choose to use the contagion model to price basket CDS. This study assumes that a basket of reference assets is defaultable and that defaults between two counterparties are contagious. Without taking into account the default of the CDS buyer, we assume that both the interest rate and the default intensity of the reference assets follow the Vasicek model. We obtain the related probability density function by the PDE method. Under the no‐arbitrage principle, we set up several scenarios to get the basket CDS pricing formula. In the numerical analysis part, we verify the validity of the formula by Monte Carlo simulation, and discuss the influence of the main parameters on the formula.

An empirical evaluation of alternative fundamental models of credit spreads

This study conducts an empirical comparison of how well alternative models of credit spreads explain CDS prices on 145 companies over the 2008–2019 interval. The results indicate that credit spreads are most closely related to theories which incorporate the likelihood of income insolvency into measures of the risk of jumps to default, with over half of individual CDS prices being explained, both during the financial crisis and thereafter. Out-of-sample tests using the same parameters estimated in-sample for all companies across time indicate that models which integrate the probability of income, cash, and valuation insolvency explain over 70% of spreads.

Credit derivatives and corporate default prediction

There have been 128 defaults among U.S. CDS reference entities between 2001 and 2020. Within this sample, the five-year CDS spread is a significant predictor of corporate default in models with equity market covariates and firm attributes. This finding holds for forecast horizons up to 12 months, among financial and non-financial firms, within and without the great financial crisis, and is robust to the inclusion of corporate bond and equity options market information. A decomposition of the CDS spread into liquidity, physical default, and risk premium components shows that most of its predictive power for corporate default comes from the physical default component, both in- and out-of-sample. These results confirm the relevance of information contained in single-name CDS pricing to corporate default prediction.

Basket Credit Default Swap Pricing with Two Defaultable Counterparties

In this paper, we study the basket CDS pricing with two defaultable counterparties based on the reduced‐form model. The default jump intensities of the reference firms and counterparties are all assumed to follow the mean‐reverting constant elasticity of variance (CEV) processes. Taking the Vasicek process which is a special case of CEV process as an example, the approximate analytic solutions of the joint survival probability density, the probability densities of the first default and the first two defaults can be solved by using PDE method. In addition, we also extend the Vasciek process to the Vasciek process with cojumps and obtain the approximate closed‐form solutions of the relevant default probability densities. Then with the expressions of the probability densities, we can get the formula of the basket CDS price with two defaultable counterparties. In the numerical analysis, we do sensitivity analysis and compare the basket CDS prices under our model with that with only one defaultable counterparty. The numerical results show that our model can be applied into practice.

Investigating the behaviour of sovereign risk for Eurozone countries

ABSTRACT The article examines the determinants of sovereign risk for European Monetary Union countries taking into consideration the global financial crisis, which emerged as a sovereign debt crisis in Europe. Using CDS prices, as a proxy of sovereign risk, this study finds that bond yields, equity prices and exchange rate are the key drivers of CDS prices. Moreover, our findings support models with dynamic components and regional effects between core and peripheral Eurozone countries, providing evidence of major differences in risk evaluation.

CDS pricing with fractional Hawkes processes

We propose a fractional self-exciting model for the risk of corporate default. We study the properties of a time-changed version of an intensity based model. As a time-change, we use the inverse of an α-stable subordinator. Performing such a time-change allows to incorporate two particular features in the survival probability curves implied by the model. Firstly, it introduces random periods of time where the survival probability is frozen, thereby modeling periods of time where the viability of the company is not threatened. Secondly, the time-change implies possible sharp drops in the survival probability. This feature corresponds to the occurrence of one-time events that threaten the creditworthiness of the company. We show that the joint probability density function and Laplace transform of the time-changed intensity and associate compensator are solutions of fractional Fokker–Planck equations. After a discussion regarding approximation of Caputo fractional derivatives, we describe a simple and fast numerical method to solve the Fokker–Planck equation of the Laplace transform. This Laplace transform is used to obtain the survival probabilities implied by our model. Finally, we use our results to calibrate the model to real market data and show that it leads to an improvement of the fit.

Do Well-Behaved Firms Attract More Market Makers? Evidence from the CDS Market

This paper explores whether corporate social performance impacts CDS market liquidity. We first document that better corporate social performance attracts more CDS market makers and induces more frequent CDS price updates. Second, we explore the influence mechanism of CSR on CDS market liquidity. Cross-sectional analyses show that the effect of CSR on liquidity provision is stronger for firms with smaller sizes, fewer analysts following, higher stock return volatility, higher systematic risk or higher credit risk. These findings are consistent with the notion that strong social performance attracts CDS dealers by reducing information asymmetry or offsetting firm risk. Our findings are robust to controlling for more variables, remain qualitatively similar for three subperiods around the 2008 financial crisis period and are robust to the acquisition of CSR data vendors. To our knowledge, this is the first study to focus on the relation between corporate social responsibility and financial market microstructure.

Measuring and Stress-Testing Market-Implied Bank Capital

We propose a methodology for measuring the market-implied capital of banks by subtracting from the market value of equity (market capitalization) a credit-spread-based correction for the value of shareholders' default option. We show that without such a correction, the estimated impact of a severe market downturn is systematically distorted, underestimating the risk of banks with a low market capitalization. We argue that this adjusted measure of capital is the relevant market-implied capital measure for policy makers. We propose an econometric model for the combined simulation of equity and CDS prices, which allows us to introduce this correction in the SRISK framework for measuring systemic risk.

How does standardization affect OTC markets? Evidence from the Small Bang reform in the CDS market

Focusing on the most liquid segment of the European CDS market, this paper studies the impact of key standardization reforms. We document that the introduction of an upfront fee to standardize the cash flow of CDS contracts created an initial capital cost for traders, leading to higher CDS prices. This relation holds after accounting for well-known determinants of spreads, suggesting a separate funding channel driven by the greater capital intensity of trading. This effect is stronger when dealers are likely to bear the initial capital cost and is present across all industries, except for swaps written on financials.

Causality Between Stock Market and Macroeconomic Variables in Turkey: New Evidence From Wavelet Coherence Analysis

We examine the dependence and causal linkages among selected macroeconomic variables, namely BIST100, bond yields, CDS, currency basket, and gold prices, in Turkey. Using daily data covering the period 2011-01-14 to 2019-04-30, we find the following empirical results. First, all variables are found to be integrated into the first order, namely stationary in first log-difference. Second, our paper detects evidence of significant interdependence in thirteen out of twenty pairs of variables. Third, the findings of the VECM test reveal unidirectional and bidirectional causalities in the short- and long-run. Fourth, the results of wavelet coherence analysis highlight a negative relationship for the pairs of BIST100-currency basket and BIST100-gold prices while positive linkages are observed for the pairs of bond rates-currency basket, bond rates-gold prices, and CDS-gold prices. In addition, the BIST100 index unidirectionally leads currency basket between 16- and 128-day holding periods between 2013-2017 years. Lastly, there exist unidirectional causal linkages among changes in prices for all the pairs of variables, except for BIST100-CDS with noncausality and gold-currency basket with two-way causality. Our findings yield significant implications for portfolio and risk management and financial stability.

Credit Derivatives and Corporate Default Prediction

There have been 128 defaults among U.S. CDS reference entities between 2001 and 2020. Within this sample, the five-year CDS spread is a significant predictor of corporate default in models with equity market covariates and firm attributes. This finding holds for forecast horizons up to 12 months, among financial and non-financial firms, within and without the great financial crisis, and is robust to the inclusion of corporate bond and equity options market information. A decomposition of the CDS spread into liquidity, physical default, and risk premium components shows that most of its predictive power for corporate default comes from the physical default component, both in- and out-of-sample. These results confirm the relevance of information contained in single-name CDS pricing to corporate default prediction.

Art-Backed Lending: Implied Spreads and Art Risk Management

The increasing portion of individuals' wealth in art sets the stage for art-backed lending services. Considering widely used credit default swaps, the paper applies the structure to art-backed loans and develops an extensive pricing model for the derivatives contract, explicitly taking art market characteristics into account. Using a CDS pricing methodology sheds light on current lending spreads and provides a risk management tool for art-backed lending institutions. At the same time, an introduced art credit default swap would offer an ability to transfer the lender's risk with respect to the art price. The results suggest that credit risk accounts for at most 50% of current art-backed lending spreads.

The Market Impact of Systemic Risk Capital Surcharges

This paper tests whether an increase or decrease of the capital surcharge for being a global systemically important bank (G-SIB) envisaged by regulators has an impact on the CDS prices of these banks. We find evidence that the CDS spreads of a G-SIB bank increase (decrease) after the announcement of a higher (lower) capital surcharge. However, this effect is temporary, as the mean CDS spreads revert to pre-announcement level, dropping sharply after the initial rise. Our analysis contributes to the debate on whether being designated as a G-SIB bank necessarily leads to implicit too-big-to-fail subsidies. The findings imply that the investors immediately update their beliefs on the systemic risk of the bank after the bucket reallocation announcement and temporarily demand more hedging against systemic risk.

An Analysis of Sovereign Credit Risk Premia in the Euro Area: Are They Explained by Local or Global Factors?

We study the determinants of sovereign credit risk in the euro area in a time period that includes the financial and sovereign debt crisis, as well as the unconventional monetary policy adopted by the European Central Bank. First, we detect the presence of commonality in sovereign credit spreads of different countries, justifying the search for the common factors that drive CDS prices. Building on the work of Longstaff et al. (2011), we employ the econometric model used in Cecchetti (2017) to decompose sovereign credit default swap spreads into expected default losses and risk premia, finding evidence of a significant contribution of the latter component. We use the model to understand to what extent the variations in CDS spreads and in the two embedded components of selected euro-area countries are more linked to local or euro area economic variables. The results point to the importance of both global and local factors, which have a greater impact on the risk premium component. Finally, we estimate the contribution of the objective probability and risk premium components of redenomination risk (as measured by the ISDA basis) to the related CDS spread components, detecting some differences between countries.

An Integrated Analysis of the Fundamental Determinants of Credit Risk Premiums on Corporate Debt

This research investigates the fundamental components of corporate credit spreads through an integrated examination of how well different models, default probability functions, and market factors explain CDS prices. Individual company yield spreads are discovered to be determined by the interrelated risks of cash, income, and valuation insolvency, along with various measures of systematic downside risk. The empirical findings indicate that the priced risk of a jump to and at default is well explained by those fundamentals, including in ex-post tests, although the financial determinants of credit spreads are found to vary significantly across different groups of companies.

Explaining CDS prices with Merton’s model before and after the Lehman default

We examine whether CDS prices around the Credit Crisis can be explained with Merton’s model. First we invert the model with market prices to reveal skewed volatility smiles over the whole 2005–2012 period. Then we calibrate the model to pre-Crisis data in two novel ways that allow for skewness, one based on equity-index options (MEIV) and the other on the sensitivity of CDS prices to equity volatility (MSKEW). In out-of-sample forecasts both calibrations match the in-Crisis peak of prices, but the second is better at capturing the systematic component of prices thereafter. Average CDS prices remain at twice their pre-Crisis level long after that event; the MSKEW calibration demonstrates that this is due to extra idiosyncratic risks, which are important for some firms but have negligible impact on others.

Volatility relation between credit default swap and stock market: new empirical tests

This paper investigates the relation between volatility of CDS and stock prices using a sample of 109 European investment-grade companies, during the period of January 2012 to January 2016. To analyse the volatility relation between CDS and stock prices and its time persistence, we use the Dynamic Conditional Correlation (DCC) model. We also test the volatility spillover hypothesis and investigate the direction of the spillover effect using the BEKK-GARCH model. We find strong evidence in support of the hypothesis that the volatility of CDS and stock prices across European investment-grade companies can be modelled under the dynamic conditional correlation assumption. When we split the volatility into two components, namely, ARCH-effect (that is, short-run persistence of shocks) and GARCH-effect (that is, long-run persistence), we find that, in general, the persistence of correlation is statistically significant, while the impact of innovations (shocks) on correlation is not. Our tests of the volatility spillover hypothesis provide new evidence that the volatility spillover is bi-directional, with the predominant leadership of the European CDS market over the stock market.

Predicting Credit Default Swap (CDS) Returns with Machine Learning

Credit Default Swaps (“CDS”) are contracts that insure one party against default in an underlying financial instrument, usually a bond. Therefore, the price of CDS reflects the perceived risk of default in an underlying financial instrument. This project applied Support Vector Machines (“SVMs”) to the prediction of CDS price changes for several individual companies across time. Previous research applying SVMs to predicting CDS prices used historical CDS prices as model inputs. This project proposed and applied several new input variables. Tests over a period of several years, across a group of CDS time-series, indicate that a combined model which uses the new input variables in addition to historical CDS price changes outperforms models that only use historical CDS price changes.

Counterparty Credit Risk and the Effectiveness of Banking Regulation

We investigate how counterparty credit risk influences the prices of over-the-counter CDS contracts using confidential transaction level data for practically all Dutch trades. We confirm our prior of a significant negative relationship between the credit worthiness of the CDS seller and the price of the CDS contract. We find that an increase of 100 basis points in the credit spread of the seller, decreases the price of the CDS contract by 7.2 basis points. Also, the larger the size of the CDS contract the lower the price of the CDS contract. Finally, we find that regulatory exemptions have a statistically significant but economically negligible impact on CDS pricing: Transactions exempted from banking capital requirements for Credit Valuation Adjustment risk – mostly banks transacting with non-financial institutions, sovereigns and pension funds – trade 0.14 basis points lower, all else equal.