CDS Rates Research Articles

CDS, Faiz ve Döviz Kuru Arasındaki Nedensellik İlişkisinin Analizi: Granger Coherence Metodundan Yeni Kanıtlar

We study the relationship between weekly and monthly observations of CDS, interest, and exchange rates (USDTRY) during 2005-2020 in Turkey. The findings suggest a positive relationship between the variables. The bivariate Granger Coherence approach indicates that the dynamic causal and reverse causal interactions mainly intensify in the short- and intermediate-term. Using a bootstrap time-varying causality approach with a fixed size of 37 weeks, the casual linkages are strong but not homogenous in both non-crisis and crisis periods. There is also a unidirectional causality running from interest rates to foreign exchange rates during the period of COVID-19, yielding important implications for investors and policymakers.

Bank stability and refinancing operations during the crisis: Which way causality?

This paper explores the causality between refinancing operations of the ECB and the stability of the European banking sector during the recent crisis. We hypothesize that causality may run both ways. The ECB’s role in safeguarding the stability of the financial system suggests that refinancing operations may contribute to greater stability. Alternatively, instability in the banking sector may stimulate banks to tap liquidity at the ECB. Using country-level data on refinancing operations and bank CDS rates, we find a positive relationship between bank instability and liquidity uptake. High bank CDS rates are significantly related to the decision to tap liquidity, yet the liquidity uptake itself does little to bring these rates down quickly.

Intra-Market Correlations in the Bond Markets: Extending Empirical Regularities from the Equity Markets

The capital markets in general, and the equity markets in particular, exhibit a well-known phenomenon: During times of distress, intra-market correlations tighten, as traded assets exhibit a greater sensitivity to the systematic factor. This paper extends that analysis to the corporate bond markets, by demonstrating that the fixed-income markets exhibit that same empirical regularity. Specifically, capitalizing on the liquidity of corporate CDS rates, we use this data to demonstrate how these intra-market correlations tightened during recent periods of crisis. Whereas most components of capital markets have substantially recovered from their crisis magnitudes, our analysis of the distribution of pair-wise CDS correlations demonstrates a recovery from crisis levels -- but, as of 2015, not yet to pre-crisis levels.

CDS Rate Construction Methods by Machine Learning Techniques

Regulators require financial institutions to estimate counterparty default risks from liquid CDS quotes for the valuation and risk management of OTC derivatives. However, the vast majority of counterparties do not have liquid CDS quotes and need proxy CDS rates. Existing methods cannot account for counterparty-specific default risks; we propose to construct proxy CDS rates by associating to illiquid counterparty liquid CDS Proxy based on Machine Learning Techniques. After testing 156 classifiers from 8 most popular classifier families, we found that some classifiers achieve highly satisfactory accuracy rates. Furthermore, we have rank-ordered the performances and investigated performance variations amongst and within the 8 classifier families. This paper is, to the best of our knowledge, the first systematic study of CDS Proxy construction by Machine Learning techniques, and the first systematic classifier comparison study based entirely on financial market data. Its findings both confirm and contrast existing classifier performance literature. Given the typically highly correlated nature of financial data, we investigated the impact of correlation on classifier performance. The techniques used in this paper should be of interest for financial institutions seeking a CDS Proxy method, and can serve for proxy construction for other financial variables. Some directions for future research are indicated. Thanks for the feedbacks from participants at the conferences/seminars; please feel free to check out some of the updated presentation slides: 1. Departmental Seminar of Statistics at London School of Economics, London, Mar. 2017; 2. New Methods, Perspectives and Approaches Seminar at Bank of England, London, Oct. 2017; 3. Machine Learning and AI in Quantitative Finance 2017 Conference, London, Nov. 2017; 4. Machine Learning and AI in Quantitative Finance 2018 Conference, London, Mar. 2018; 5. Call for Paper 2018 Winner of Risk's Quant Summit Europe Conference, London, Mar 2018; 6. Global Finance Conference Jun. 2018, Paris; 7. 10th World Congress of Bachelier Finance Society Jul. 2018, Dublin.

The information content of the open interest of credit default swaps

This article addresses the information content of the open interest of CDS markets. Using a panel database of 481 firms, I show that open interest innovations help to predict subsequent CDS rate changes and stock returns. The open interest dynamics appears to convey specific information on the reference entity and common information. On the one hand, there is evidence that positive open interest growth precedes the announcement of negative earnings surprises, and that high open interest growth prior to these events is linked to positive and significant CDS rate changes. This forecasting power relates with proxies of investors’ attention and market frictions. The predictive power on CDS rates is larger for illiquid contracts and for entities with low credit risk, whereas the predictive power over stock returns is larger for entities that display greater open interest outstanding. On the other hand, this article also shows that the aggregate open interest growth has predictive power on the subsequent returns of CDS and bond main indexes, and to a lesser extent on stock market returns.

M&A operations: Further evidence of informed trading in the CDS market

Previous studies showed that private information gathered through banking services such as loans and syndicated debt is incorporated into CDS rates by large banks. Additionally, there is also evidence that innovations in CDS rates precede stock market returns prior to credit events. This paper adds to the literature by showing that the information obtained by major banks while providing M&A investment banking services is assimilated by CDS rates prior to the operation announcement. We also find strong supportive evidence that CDS innovations have incremental predictive power over stock returns before M&A announcements, and that this predictive power may be even greater when major dealers in the CDS market supplied investment banking services to one of the parts of the deal.

FVA and CVA under margining

Purpose – The purpose of this paper is to provide a framework of replication pricing of derivatives and identify funding valuation adjustment (FVA) and credit valuation adjustments (CVA) as price components. Design/methodology/approach – The authors propose the notion of bilateral replication pricing. In the absence of funding cost, it reduces to unilateral replication pricing. The absence of funding costs, it introduces bid–ask spreads. Findings – The valuation of CVA can be separated from that of FVA, so-called split up. There may be interdependence between FVA and the derivatives value, which then requires a recursive procedure for their numerical solution. Research limitations/implications – The authors have assume deterministic interest rates, constant CDS rates and loss rates for the CDS. The authors have also not dealt with re-hypothecation risks. Practical implications – The results of this paper allow user to identify CVA and FVA, and mark to market their derivatives trades according to the recent market standards. Originality/value – For the first time, a line between the risk-neutral pricing measure and the funding risk premiums is drawn. Also, the notion of bilateral replication pricing extends the unilateral replication pricing.

A MULTIVARIATE JUMP DIFFUSION PROCESS FOR COUNTERPARTY RISK IN CDS RATES

We consider counterparty risk in CDS rates. To do so, we use a multivariate jump diffusion process for obligors’ default intensity, where jumps (i.e. magnitude of contribution of primary events to default intensities) occur simultaneously and their sizes are dependent. For these simultaneous jumps and their sizes, a homogeneous Poisson process. We apply copuladependent default intensities of multivariate Cox process to derive the joint Laplace transform that provides us with joint survival/default probability and other relevant joint probabilities. For that purpose, the piecewise deterministic Markov process (PDMP) theory developed in [7] and the martingale methodology in [6] are used. We compute survival/default probability using three copulas, which are Farlie-Gumbel-Morgenstern (FGM), Gaussian and Student-t copulas, with exponential marginal distributions. We then apply the results to calculate CDS rates assuming deterministic rate of interest and recovery rate. We also conduct sensitivity analysis for the CDS rates by changing the relevant parameters and provide their figures.

Common Factors in Default Risk Across Countries and Industries

Global economic crises appear to strongly affect corporate bankruptcy rates. However, several prior studies indicate that changes in default risk are strongly negatively related to equity returns, which in turn depend predominately on country-specific factors. This suggests that country effects - and not global effects - should dominate changes in default risk. To analyze this issue, we decompose changes to default risk, changes to the fundamental determinants of default risk and equity returns into global, country and industry effects. We proxy for default risk through Merton (1974) default risk estimates and CDS rates. Our evidence reveals that changes in default risk always depend most strongly on global and industry effects. However, the magnitude of country effects in equity returns correlates positively with economic stability, rendering it dependent on the studied sample period. Our results have implications for the management of credit-sensitive securities.

Fiscal space and sovereign risk pricing in a currency union

We examine how membership in a currency union affects public debt sustainability and market assessments of default risk in eurozone countries. We argue that there exist offsetting effects: expectations of bailouts tend to make a given level of debt more sustainable, lowering bond yields and CDS rates, but constraints on the use of monetary policy would tend to have the opposite effect, pushing rates up especially as room for fiscal maneuver gets exhausted. We develop a formal concept of fiscal space (which takes account of the notion of fiscal fatigue under which there are limits to the government's ability to raise the primary surplus in response to higher debt), and apply it to the eurozone countries, investigating in particular how currency union membership affects CDS and bond rates during both quiet and turbulent times for a given amount of fiscal space. We find that in quiet times, CDS and bond rates for eurozone members were below what would be expected given their fiscal space (a bonus from currency union membership). But when the crisis erupted, CDS and bond yields rose more sharply for eurozone members than would be predicted based on their available fiscal space. Our interpretation is that sovereign bailouts did not occur with the hoped-for alacrity in euro-crisis countries, generating sharper penalties for sovereigns that belong to a currency union.

Sovereign debt exposures and banking risks in the current EU financial crisis

This paper explores the relationship between sovereign risk and banking risk during the European sovereign debt crisis in May 2010. We link banks’ stock returns and CDS rates to sovereign CDS rates, to examine the spillover of sovereign risk to the banking system in the EU. More specifically, we use sovereign debt exposures from the EU's July 2010 stress tests to investigate whether heavily exposed banks were hit harder during the May 2010 crisis. The results are mixed. Banks exposed to distressed sovereign debt respond more strongly to changes in sovereign CDS rates. On closer examination, however, this result appears to be driven by banks which are located in countries experiencing sovereign debt problems.

Conditional Jumps in Volatility and Their Economic Determinants

The volatility of financial returns is affected by rapid and large increments. Such movements can be hardly generated by a pure diffusive process for stochastic volatility. On the contrary jumps in volatility are important because they allow for rapid increases, like those observed during stock market crashes. We propose an extension of HAR model for estimating the presence of jumps in volatility, using the realized-range measure as a volatility proxy. By focusing on a set of 36 NYSE stocks, we show that, once that squared jumps in prices are disentangled from integrated variance, then there is a positive probability of jumps in volatility, conditional on the past information set. We then focus on the contribution of jumps during periods of financial turmoil. We analyze the dependence between the first principal component of the volatility jumps with a set of financial covariates including VIX, S&P500 volume, CDS, and Federal Fund rates. We observe that CDS captures large part of the expected jumps moves, verifying the common interpretation that large and sudden increases in volatility in stock markets over some days in the recent financial crisis have been caused by credit deterioration of US bank sector. Finally, we extend the model incorporating the credit-default swap in the dynamics of the jump size and intensity. The estimates confirm the significant contribution of the credit-default swap to the dynamics of the volatility jump size.

Financial CDS, stock market and interest rates: Which drives which?

The objective is to examine the short- and long-run dynamics of US financial CDS index spreads at the sector level and explore their relationships with the stock market and the short- and long-run government securities, paying particular attention to the subperiod that begins with the 2007 Great Recession. We use daily time series for the three US five-year CDS index spreads for banking, financial services and insurance sectors, the S&P 500 index, the short- and long-term Treasury securities rates. Employing the Autoregressive Distributed Lag approach (ARDL), this study finds more long-run relationships between the five financial variables in Model II that includes the six-month T bill rate than Model I that includes the 10-year T bond rate. The long-run relationships have weakened in both models under the subperiod than the full period. Moreover, the short-run dynamics have changed under the subperiod but the changes are mixed. Implications are relevant for decision-makers who are interested in financial relationships at the sector level than at the firm level.

Common Factors in Default Risk Across Countries and Industries

AbstractGlobal economic crises appear to strongly affect corporate bankruptcy rates. However, several prior studies indicate that changes in default risk are strongly negatively related to equity returns, which in turn depend predominately on country‐specific factors. This suggests that country effects – and not global effects – should dominate changes in default risk. To analyse this issue, we decompose changes in default risk, changes in the fundamental determinants of default risk and equity returns into global, country and industry effects. We proxy for default risk through Merton (1974) default risk estimates and CDS rates. Our evidence reveals that changes in default risk always depend most strongly on global and industry effects. However, the magnitude of country effects in equity returns correlates positively with economic stability, rendering it dependent on the sample period. Our results have implications for the management of credit‐sensitive securities.

The cost of operational risk loss insurance

Using the Algo FIRST operational risk database, this paper computes the cost of operational risk loss insurance for a sample of banks over a 1-year horizon. The estimated cost of 1-year operational risk loss insurance for an average bank is 1.24% as a percentage of firm value on December 31, 2006, while an average AA bank is 0.24%. These estimates far exceed the typical 1-year default insurance premiums as reflected in market CDS rates for similarly rated banks. These insurance premiums confirm the economic importance of operational risk in the management of financial institutions.

Basket CDS pricing with interacting intensities

We propose a factor contagion model for correlated defaults. The model covers the heterogeneous conditionally independent portfolio and the infectious default portfolio as special cases. The model assumes that the hazard rate processes are driven by external common factors as well as defaults of other names in the portfolio. The total hazard construction method is used to derive the joint distribution of default times. The basket CDS rates can be computed analytically for homogeneous contagion portfolios and recursively for general factor contagion portfolios. We extend the results to include the interacting counterparty risk and the stochastic intensity process.

Ambiguity Shifts and the 2007-2008 Financial Crisis

I analyze the effects of model misspecification on default swap spreads and equity prices for firms that are not perfectly transparent to the investors. The agents in the economy are misspecification-averse and thus assign higher probabilities to lower utility states. This leads to higher CDS rates, lower equity prices and lower expected times to default. Estimating the model using data on financial institutions, I find that the sudden increase in credit spreads in the summer of 2007 can be partially explained by agents' mistrust of the signals observed in the market. The bailout of Bear Stearns in March 2008 and the liquidation of Lehman Brothers in September 2008 further exacerbated the agents' doubts about signals quality and introduced mistrust about the agents' pricing models, accounting for the further increases in credit spreads after these events.

Constant Maturity Credit Default Swap Pricing with Market Models

In this work we derive an approximated no-arbitrage market valuation formula for Constant Maturity Credit Default Swaps (CMCDS). We move from the CDS options market model in Brigo (2004), and derive a formula for CMCDS that is the analogous of the formula for constant maturity swaps in the default free swap market under the LIBOR market model. A convexity adjustment-like correction is present in the related formula. Without such correction, or with zero correlations, the formula returns an obvious deterministic-credit-spread expression for the CMCDS price. To obtain the result we derive a joint dynamics of forward CDS rates under a single pricing measure, as in Brigo (2004). Numerical examples of the convexity adjustment impact complete the paper.