Credit Default Swap Market Research Articles

Corporate Payout Policy and Credit Risk: Evidence from Credit Default Swap Markets

We examine whether and how payout policy affects credit risk using evidence from the credit default swap (CDS) market. CDS spreads increase substantially in response to announcements of dividend cuts, especially during recessions and among firms experiencing financial distress. CDS spreads also react more strongly to permanent and less anticipated dividend cuts. The size of the CDS reaction is more pronounced for financial firms, which are inherently more opaque. In contrast, CDS spreads react weakly to dividend raises and share repurchases. The results show that the information effect of dividend changes dominates the wealth-transfer effect. This paper was accepted by Kay Giesecke, finance.

Short selling disclosure and its impact on CDS spreads

The European Union introduced Regulation 236/2012 in 2012 to address short selling and certain aspects of credit default swaps (CDS). Consequently, a uniform short position disclosure regime was developed, which is used in this paper to examine CDS spreads as a proxy for credit risk around public short sale announcements and evaluate the disclosure policy's relevance from the debtholder's perspective. Existing literature documents short selling regulations’ impacts on the stock market, but no evidence exists from the CDS market. Therefore, we first conduct an event study to examine the effects of different short sale events on corresponding firms’ CDS spreads between 2012 and 2018. Moreover, we use regression analyses to control for several credit risk determinants that may also affect CDS spreads. Our evidence suggests that opening and increasing short positions are perceived as negative information, and in this regard lead to higher CDS spreads. In contrast, CDS spreads tend to be lower if short positions decrease or close. Additionally, we find that negative information ceteris paribus more strongly affects CDS spreads than positive information. Finally, we investigate certain anticipatory reactions when negative news enters the CDS market.

An Incentive Mechanism Model of Credit Behavior of SMEs Based on the Perspective of Credit Default Swaps

The rapid development of credit default swap (CDS) market has changed the manner of credit risk management of banks to some extent and has had a new influence on the bank-enterprise credit model. In this study, the credit financing process of credit risk in small- and medium-sized enterprises (SMEs) gathers within a bank, which makes it difficult for SMEs to raise funds. On the basis of the perspective of CDS, we construct an incentive game model of bank-enterprise credit behavior and analyze the influence mechanism of the credit financing of SMEs on CDS contract coupon rate, CDS payout ratio, bank-enterprise credit effort, and loan recovery rate when considering CDS. The result shows that the CDS contract leads to insufficient supervision after a bank loan, the moral hazard of the SMEs rises, and the probability of credit default events increases. In addition, in view of CDS, the SMEs can access more credit funds.

The role of the leverage effect in the price discovery process of credit markets

Starting from the analysis of a levered firm’s capital structure, I show that corporate default risk becomes measurable through the leverage effect, i.e., the negative correlation observed between stock returns and changes in stock volatility. In this model, the firm’s debt-to-asset ratio governs the elasticity of default probabilities relative to equity prices. I use a large dataset of S&P 500 firms and an extended timeframe (2008–2019) to examine the model’s empirical implications. First, the firm’s corporate leverage enhances the transmission of pricing information from the stock to the credit default swap (CDS) market. Second, equity and credit markets are more likely to be co-integrated when firms employ a higher debt-to-asset ratio. Although the stock market generally dominates the price discovery process, a small cluster of highly-leveraged firms exhibits a dominant CDS market share. Under the effect of corporate leverage, the credit market attracts informed trading and arbitrage resources.

Bad or good neighbours: a spatial financial contagion study

PurposeThe purpose of this paper is to study the evolution of financial contagion between Eurozone banks, observing the credit default swaps (CDSs) market during the period 2009–2017.Design/methodology/approachThe authors use a dynamic spatial Durbin model that enables to explore the direct and indirect effects over the short and long run and the transmission channels of the contagion.FindingsThe results show how contagion emerges through physical and financial market links between banks. This finding implies that a bank can fail because people expect other related financial institutions to fail as well (self-fulfilling crisis). The study provides statistically significant evidence of the presence of credit risk spillovers in CDS markets. The findings show that equity market dynamics of “neighbouring” banks are important factors in risk transmission.Originality/valueThe research provides a new contribution to the analysis of EZ banking risk contagion, studying CDS spread determinants both under a temporal and spatial dimension. Considering the cross-dependence of credit spreads, the study allowed to verify the non-linearity between the probability of default of a debtor and the observed credit spreads (credit spread puzzle). The authors provide information on the transmission mechanism of contagion and, on the effects among the largest banks. In fact, through the study of short- and long-term impacts, direct and indirect, the paper classify banks of systemic importance according to their effect on the financial system.

Asymmetric information in the equity market and information flow from the equity market to the CDS market

We investigate whether asymmetric information in the equity market affects the information flow from the equity market to the credit default swap (CDS) market. We find that the response to stock price changes is larger if they are more informative. Moreover, firms with a lower CDS bid–ask spread are associated with a more rapid response. Our results suggest that asymmetric information in the equity market mainly impacts cross-sectional differences in the total response of the CDS market. Our evidence indicates that this effect is amplified when sentiment-driven trading declines in the equity market or transaction costs are low in the CDS market.

Contagion between liquid and illiquid assets during the financial crisis: evidence from the US credit derivative market

This study aims to investigate the existence of contagion between liquid and illiquid assets in the credit default swap (CDS) market around the recent financial crisis. The authors perform analyses based on vector autoregression model and the dynamic conditional correlation model. The estimation of vector autoregression models reveals that changes in liquid CDS (LCDS) spreads lead to changes in illiquid CDS spreads at least one week ahead during the financial crisis period, whereas the leading direction is reversed during the post-crisis period. Moreover, the results are robust after controlling for structural variables which are proven as determinants of CDS spreads and are empirically supported. This study interprets that information was incorporated first into the LCDSs because of the flight-to-liquidity during the recent crisis period but there is a default contagion effect by reflecting illiquidity-induced credit risk after the crisis. Finally, the dynamic conditional correlation analysis also confirms the main results.

Sovereign CDS Market: The Role of Dealers in Credit Events

In this paper, we study the credit default swaps (CDS) position of the main dealers in the CDS market close to credit events of sovereign countries. We focus on the credit events of three countries that have faced significant financial distress in the past decade: Argentina, Venezuela, and Ukraine. After introducing the historical background of each country, we find that CDS dealers, defined as the top ten traders of CDS in their respective countries, tend to sell sovereign CDS (hold more negative or less positive positions) when yields/CDS spreads go up. This finding suggests that dealers perform the role of liquidity providers in times of financial distress and take the credit risk that smaller traders want to unload into the market.

Network structures and idiosyncratic contagion in the European sovereign credit default swap market

This study combines conditional Granger causality and network analysis to examine the interconnectedness in the European sovereign credit default swap (CDS) market. We determine that the network is unstable in the short term and stable in the long term. Further, we visualize dynamic networks and confirm financial contagion in the 2012 European debt crisis. The sources of risk spillovers and the manner in which spillovers are transferred among countries are identified accordingly. Further, we conclude that interconnectedness can be a pricing factor for determining the sovereign CDS return. The results of the network analysis indicate that the European sovereign CDS market is a complex network system and can serve as a valuable reference for investors and policymakers.

Sovereign credit ratings and CDS spreads in Emerging Europe

Research background: Sovereign credit ratings play an important role in determining any country?s access to the international debt market. During the global financial crisis and the European debt crisis, credit rating agencies were harshly criticized for the timing of their announcements regarding ratings downgrades and the ranges of those downgrades. Therefore, it is worth considering whether the sovereign credit rating is still a useful benchmark for investors.
 Purpose of the article: This article examines whether credit rating agencies still provide financial markets with new information about the solvency of governments in Emerging Europe countries. In addition, it describes the differences in the effect of particular types of rating events on financial markets and the impact of individual agencies on the market situation. Our study also focuses on evaluating these occurrences at different stages of the business cycle.
 Methods: This article uses data about ratings events that took place between 2008 and 2018 in 17 Emerging Europe economies. We took into consideration positive, neutral, and negative events related to ratings changes and the outlooks reported by Fitch Ratings, Moody?s, and Standard & Poor?s. We used a methodology based on event studies. In addition, we performed Wilcoxon signed-ranks test and used a logit model to determine the usefulness of cumulative adjusted credit default swap (CDS) spread changes in predicting the direction of ratings changes.
 Findings & Value added: Our research provides evidence that the CDS market reflects information regarding government issuers up to three months before ratings downgrades are announced. Information reported to the market by ratings agencies is only relevant in the short timeframe surrounding ratings downgrades and upgrades. However, positive credit rating changes convey more information to the market. We also found strong evidence that, in the post-crisis period, credit ratings provide markets with less information.

Investor Attention towards coronavirus and response of Stock and Sovereign Credit Default Swaps Markets

We use search queries with the word “CORONAVIRUS” in Google Trends as a proxy for investors’ attention and track its impact on the stock markets and sovereign risk. By using daily data of 41 countries for the period of January-June 2020, it is found that increased coronavirus related search is negatively linked with stock market returns and positively linked with country risk. Further, stock market returns are depressed, and sovereign risk is higher in developed countries than emerging countries in response to rising concern about the spread of COVID-19.

Counterparty choice in the UK credit default swap market: An empirical matching approach

Adopting a novel empirical matching game framework, we investigate how market participants determine their trading partners in credit default swap transactions, which has received less attention in the literature. Using UK regulatory data at the transaction and identity levels for years 2012–2014, we find evidence that market participants prefer trading with organisations with larger total assets and more market activities. Our findings explain the too-big-to-fail problem in the credit default swap market, where market participants believe that regulators may not allow organisations with too many affected creditors to fail. Additionally, dealers with more intermediation activities are more likely selected as trading partners, implying the self-reinforcing nature of the market, which could exacerbate the too-big-to-fail problem. Counterparty risk also plays a significant role in trade pairing, but its effect differs across organisation types. For example, hedge funds prefer trading with risky counterparties before 2014, leading to a greater contagion risk.

The Relative Role of Sovereign CDS and Bond Markets in Efficiently Pricing Emerging Market Sovereign Credit Risk

Extant literature reports mixed findings on the relative efficiency of credit default swaps (CDS) and bond markets in pricing emerging market sovereign credit risk. Using a more comprehensive data set than analyzed earlier, we reexamine this issue and find that CDS dominate bonds in the price discovery of this risk, an advantage we attribute to the greater relative liquidity of that market. One exception is during the financial crisis, suggesting that when panic hits, sovereign markets price credit risk differently. However, even then, the CDS market has a greater impact on price discovery than the bond market, indicating greater overall efficiency. JEL Classification: G11, G12, G13, G14, G23

Does the CDS Market Reflect Regulatory Climate Risk Disclosures?

We use BERT, an AI-based algorithm for language understanding, to decipher regulatory climate-risk disclosures and measure their impact on the credit default swap (CDS) market. Risk disclosures can either increase or decrease credit spreads, depending on whether disclosure reveals new risks or sharpens the signal and decreases the uncertainty. Training BERT to differentiate between transition and physical climate risks, we find that disclosing transition risks increases CDS spreads, especially after the Paris Climate Agreement of 2015, while disclosing physical climate risks leads to a decrease in CDS spreads. These impacts are statistically and economically highly significant.

Market Structure and Transaction Costs of Index CDSs

ABSTRACTDespite regulatory efforts to promote all‐to‐all trading, the post–Dodd‐Frank index credit default swap market remains two‐tiered. Transaction costs are higher for dealer‐to‐client than interdealer trades, but the difference is explained by the higher, largely permanent, price impact of client trades. Most interdealer trades are liquidity motivated and executed via low‐cost, low‐immediacy trading protocols. Dealer‐to‐client trades are nonanonymous; they almost always improve upon contemporaneous executable interdealer quotes, and dealers appear to price discriminate based on the perceived price impact of trades. Our results suggest that the market structure is a consequence of the characteristics of client trades: relatively infrequent, large, and differentially informed.

Empirical Evidence of Co-Movement between the Canadian CDS, Stock Market And TSX 60 Volatility Index

Purpose- The prime objective of this study was to find the co-movement between the Canadian credit default swaps market, the Stock market and volatility index (TSX 60 Index) Design/ Methodology- To achieve this purpose, daily data containing 2870 observations starting from the 1st of January 2009 to the 30th of December 2019 were analyzed. This study employed the wavelet approach to present results in short-term, medium-term, long-term, and very long time. Findings- The findings of this study showed a negative correlation between the CDS market, stock market, and the TSX 60 index in the short-term as well as in the long-term term, while in medium-term and very long-term period correlation is strongly positive. The wavelet co-movement results in the short-term and long-term were negative, while this relationship in the medium-term and very long-term period was strongly positive. Practical Implications- This research provides simultaneous valuable information for investment decisions in the short, medium, and long term time horizons, as well as for the policymakers in the Canadian credit default swaps market, stock market, and the volatility index (TSX 60 Index).

Многомерная оценка стран по уровню премии за риск

The analysis of the international market for credit default swaps (CDS) shows that the interdependence of sovereign CDS spreads is increasing and the market remains segmented. However, the reduction in the variation of sovereign CDS spreads means increased competition for capital and should be taken into account by monetary authorities of developed countries when they tighten monetary policy. The article shows a significant role of political risks in determining the level of sovereign risk.

Time-Resolved Topological Data Analysis of Market Instabilities

We apply the novel econometric method, based on the time-resolved topological data analysis, to detect approaching market instabilities in multiple sectors of North American economy. Using the Takens’ embedding and the sliding window’s technique, we detect transient loops that appear in a topological space associated with financial time series and measure their persistence. The latter is encoded in Lp-norms of real-valued functions referred to as “persistence landscapes”. We study the impact of hyperparameters of the method – the size of a rolling window and the dimensionality of the Takens’ embedding – by conducting Monte Carlo simulations with surrogate time series sampled from the Student’s t-distribution with varying degrees of freedom. These numeric experiments reveal that the average value of L1-norm is growing with a rising size of a sliding window and dimensionality of embedding. This finding drives the choice of hyperparameters of the method applied to financial time series. We collect significant evidence that the variance of L1-norm derived from daily log-returns of the sector-level aggregates of credit default swap (CDS) spreads with the sliding window of 50 days and 4D embedding can serve as a leading indicator of an approaching financial crash caused by endogenous market forces and that the equity market lagged the CDS market in this discovery.

Assessing the relevance of an information source to trading from an adaptive-markets hypothesis perspective

I propose a framework motivated by the Adaptive Markets Hypothesis (AMH) to analyze the relevance of a specific information source for the trading of a given security. To illustrate the applicability and advantages of this methodology, I explore the extent to which the financial statement (FS) is relevant for Credit Default Swap (CDS) trading. Specifically, I adopt a Bayesian Model Averaging approach to examine properties of the accounting metrics that enter the implied trading heuristics of the market participants. Hypothesis-testing is conducted on various horizons around the announcement dates of corporate results. The diversity of trading rules and the shift in the heuristics mix that occurred after 2008 support the AMH perspective. Overall, results show that there is a significant component of profit-motivated trading in the CDS market that relies on financial statement information, even after controlling for information transmission from alternative trading forums. Out of sample trading strategies confirm the robustness the main findings.

The CDS Market Reaction to Loan Renegotiation Announcements

This paper analyzes the credit market's reaction to loan renegotiation announcements through changes in credit default swap (CDS) spreads. Using a sample of public US firms during the period 2010-2017, we document a positive and significant CDS market reaction (decrease in CDS spreads). The strongest reactions are for material amendments such as line of credit amount or tranche amount. On the contrary, we find no significant stock market reaction. Moreover, we identify an anticipation effect of up to 30 days before the announcement date on the CDS market. Finally, we show that firm-specific CDS returns lead the idiosyncratic component of stock returns especially around the announcement date and for speculative-rated firms.