Credit Default Swap Prices Research Articles

Credit Default Swaps Pricing Errors Reversal and Stock Market Expected Risks and Returns

This paper investigates the CDS pricing errors (CPEs) properties. I find that CPEs can significantly predict future CDS returns reversal. Consistent with mispricing channel, the predictability of CPE is particularly strong for CDS contracts with poor liquidities and for periods with high macro-uncertainty. Further analysis shows that CPEs spillover to future cross-sectional stock risks and returns but exhibit almost no predictive powers for bond returns and options returns with 1-month time-to-maturity. It suggests a closer link between equity markets and CDS markets. Collectively, CPE serves as a significant factor to affect capital market behaviors and has important implications on market efficiencies.

Pricing Credit Default Swap Subject to Counterparty Risk and Collateralization

This article presents a new model for valuing a credit default swap (CDS) contract that is affected by multiple credit risks of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to a risk-free one. In other words, full collateralization cannot eliminate counterparty risk completely in the CDS market.

Presentation and Testing of the Creeping Trend with Harmonic Weights Method in the Light of Sovereign CDS Prices

The prediction of financial indicators is not easy, as the influencing factors may change from time to time. The sovereign credit default swap (CDS) spread is a complex measure which helps evaluate country risk, and there are a number of quantitative and qualitative criteria that may have an impact on the price development. The study aims to present and test a relatively new method. Forecasting based on the creeping trend with harmonic weights allows us to manage independent variables that are not constant in time. The study presents the method and illustrates its effectiveness through an empirical example, using the Hungarian and German five-year USD denominated quarterly CDS spreads.

Relation between Credit Default Swap Spreads and Stock Prices: A Non-linear Perspective

In this study, we investigate the relation between credit risk, as implied in the credit default swaps (CDS), and market prices of Markit iTraxx Europe index companies. To test the hypothesis of co-integration between CDS and stock prices, we apply linear and non-linear models that allow for structural breaks. Using Johansen trace test of cointegration for a set of 109 pairs of CDS and stock prices of the companies included in the index, over the period of January 2012 to January 2016, we find that at the 10% level of significance, the null hypothesis of no cointegration is rejected for 26 pairs. We extend our analysis by allowing for a one-time structural break with unknown timing. Using alternative cointegration tests, we find that CDS and stock prices are cointegrated. More specifically, there are 47 companies in our sample for which CDS spreads and stock prices are cointegrated at the 10% level of significance. The existence of a long-run relation between CDS and stock prices of the European investment-grade companies is evidence for a possible transmission of shocks between the two segments of the financial market – the credit market (via CDS) and the stock market.

Cost Rigidity and CDS Spreads

We provide evidence that credit investors do not fully impound the implications of firms’ cost structure (or operating leverage) when pricing credit default swaps. Information about firms’ cost structure is not disclosed and needs to be estimated. Furthermore, the performance implications of firms’ cost structure depend on the expected macroeconomic conditions. We focus on the debt market because of the strong emphasis of this market on downside risk. To measure expected aggregate macroeconomic conditions, we employ the change in the anxious index (AI), which is the probability of a decline in real GDP provided by the SPF—the survey of professional forecasters. We find that the interaction between the firm’s cost structure and change in AI predicts one-quarter-ahead CDS spreads. Portfolio-level analysis confirms this result.

A comparison study of pricing credit default swap index tranches with convex combination of copulae

Copula as a tool for dependence modeling has been widely used in pricing portfolio-like financial derivatives, e.g. credit default swap index (CDX) tranches. Among the pricing models, the model equipped with the Gaussian copula has become the market benchmark for a long time. Albeit thereafter some other copulae were employed to improve the Gaussian model, yet a lot of them have suffered from shortcomings, especially in destitution of heterogeneous sectoral dependence, asymmetric dependence and fat tail dependence. For increasing the pricing accuracy and also keeping the model parsimonious, we propose in this paper an approach of convex combination of copulae (cc-copula) in pricing CDX tranches. Copulae from elliptical and Archimedean families were chosen as the components to construct the cc-copula models. In order to support the effectiveness of the cc-copula models, two distinct empirical studies were conducted to reproduce the spreads of the CDX tranches of two different contracts covering crisis and non-crisis periods. The results evince that the cc-copula based pricing models have dominant performance compared with the benchmark models.

CDS Trading and Stock Price Crash Risk

In this paper, we examine the impact of credit default swap (CDS) trading on the equity market in terms of stock price crash risk. We document that stock price crash is less likely after the inception of CDS trading. This evidence is consistent with the hypothesis that CDS prices reveal negative information that firms intend to hide, and information flow from the CDS market to the equity markets results in timely adjustment of stock prices and reduction of stock price crashes. We provide further evidence of the information revelation role of CDS trading by showing that CDS trading has stronger effects on reducing crash risk when firms are more likely to hide bad news in public disclosures and when executive compensation incentivizes managers to hide bad news. Our paper offers novel evidence on how a financial innovation in the debt market contributes to the stability in the equity market.

The determinants of CDS spreads: evidence from the model space

We apply Bayesian model averaging and a frequentistic model space analysis to assess the pricing determinants of credit default swaps (CDSs). Our study focuses on the complete model space of plausible models and thus supports ultimate robustness. Using a large dataset of CDS contracts we find that CDS price dynamics can be mainly explained by factors describing firms’ sensitivity to extreme market movements. More precisely, our results suggest that dynamic copula based measures of tail dependence incorporate most essential pricing information, making other potential determinants such as Merton-type factors or linear variables measuring the systematic market evolution negligible.

Numerical analysis of an extended structural default model with mutual liabilities and jump risk

We consider a structural default model in an interconnected banking network as in [1], with mutual obligations between each pair of banks. We analyse the model numerically for two banks with jumps in their asset value processes. Specifically, we develop a finite difference method for the resulting two-dimensional partial integro-differential equation, and study its stability and consistency. We then compute joint and marginal survival probabilities, as well as prices of credit default swaps (CDS), first-to-default swaps (FTD), Credit and Debt Value Adjustments (CVA and DVA). Finally, we calibrate the model to market data and assess the impact of jump risk.

Do banks’ overnight borrowing rates lead their CDS price? Evidence from the Eurosystem

Abstract We construct a measure of a bank's relative creditworthiness from the Eurosystem's proprietary inter-bank loan data: average overnight borrowing rate relative to an overnight rate index (AOR). We then investigate the dynamic relationship between AOR and the credit default swap price relative to the corresponding market index of 60 banks during 2008–2013. Price discovery mainly takes place in the CDS market, but AOR also contributes to it. The lagged daily changes of AOR help predict CDS. This indicates that AOR includes private information, which the CDS market does not immediately incorporate. We further show that the private information advantage is concentrated on days of market stress and on banks, which mainly borrow from relationship lender banks. Such borrower banks are typically smaller, have weaker ratings, and are likely to reside in crisis countries. Competent authorities can use AOR as a complementary indicator of banks’ concurrent health.

Market Credit Risk in Europe

The run-up to the Greek default featured marked increases in the cost of insuring sovereign debt from almost all European countries, as evidenced by their credit default swap (CDS) rates. One explanation for the perceived higher default risk in non-periphery countries is that market participants believed a default in the periphery might increase the risk of a future default in the core. To test for such dynamic contagion between credit related events in differing countries, we develop a procedure for tractably estimating high-dimensional Hawkes models using CDS prices. We escape the curse of dimensionality thanks to modelling the market portfolio of risk across countries, which serves as a sort of common factor. We further reduce dimensionality by taking a maximum-likelihood approach to estimation, avoiding having event intensities in the parameter set. Our approximation to the likelihood converges to the true likelihood as the sampling frequency goes to infinity; this ensures consistency even given non-stationarity, and permits tight identification. We find little evidence of shocks to one European country having an instantaneous effect on others, but risk in one country does gradually pull up risk in others.

Risk management of Credit Default Swap

Credit derivatives are an up to date innovation in financial markets. These financial instrument have a potential to allow enterprises to trade and manage the credit risks and market risks. The striking growth of credit derivatives suggest that participant of financial markets find them to be useful instrument for risk management. The most popular and fundamental credit derivatives is a credit default swaps (CDS). In the paper we detailed the risk management of the credit default swaps and quantified the credit risk of investors in two way: (i) calculate the term structure of default probabilities from the market prices of traded CDS and (ii) calculate prices of CDS from the probability distribution of the time-to-default  Keywords: credit risk; credit default swap; risk management

Risk management of Credit Default Swap

Credit derivatives are an up to date innovation in financial markets. These financial instrument have a potential to allow enterprises to trade and manage the credit risks and market risks. The striking growth of credit derivatives suggest that participant of financial markets find them to be useful instrument for risk management. The most popular and fundamental credit derivatives is a credit default swaps (CDS). In the paper we detailed the risk management of the credit default swaps and quantified the credit risk of investors in two way: (i) calculate the term structure of default probabilities from the market prices of traded CDS and (ii) calculate prices of CDS from the probability distribution of the time-to-default  Keywords: credit risk; credit default swap; risk management

An Examination of the Impact of the EU Ban on Naked Purchases of Sovereign Credit Default Swaps

We examine the impact of the November 2012 EU ban on the naked purchasing of EUsovereign credit default swaps (CDS). Using a change point model (CPM), we find thatthe ban directly reduced trading volumes for single-name CDS on EU sovereign linkedcredit. We show that the ban reduced price correlation between CDS and Eurozonesovereign bonds and we find that the tendency for CDS spread changes to ‘Grangercause’ bond spread changes dropped after the ban, with bond prices then leadingCDS prices in most core EU countries. Price discovery now occurs in the bond market.Overall, we see that the EU ban on the naked short selling of EU sovereign CDShas weakened the relationship between CDS and bond prices, making CDS hedgingless effective. We suggest that a non-functioning CDS market can lead to an increasein sovereign funding levels

Weak Convergence of Path-Dependent SDEs in Basket Credit Default Swap Pricing with Contagion Risk

We investigate computational aspects of basket credit default swap pricing with counterparty credit risk under a multiname contagion model. This model enables us to capture systematic volatility increases in the market triggered by particular bankruptcies. A drawback of this model is its analytical intractability due to a combination of path-dependent coefficients and a path-dependent functional, which furthermore causes potential failure of convergence of numerical approximations under standing assumptions. In this paper, we find sufficient conditions for the desired convergence of functionals associated with approximated solution of certain path-dependent stochastic differential equations.

Credit Default Swaps on Amr Corporation: Cash or Credit?

This case puts the students in the shoes of Jeff Thomas, a high-yield credit research analyst for a hedge fund. Thomas' portfolio manager has asked him to come up with a potential trade idea for AMR Corporation (the parent company of American Airlines) using a credit default swap (CDS). Thomas wanted to gauge whether the CDS spread prevailing in the market was too high or too low relative to AMR's credit outlook. He was going to use both structural and reduced form CDS pricing models and compare them against the prevailing CDS spreads in the market. More importantly, Thomas needed to come up with a trade recommendation. Excerpt UVA-F-1745 Mar. 9, 2016 Credit Default Swaps on AMR Corporation: Cash or Credit? As he drove home on a frigid night late on February 24, 2011, Jeff Thomas reflected on the day's events and started thinking about all the work that he would have to do after he got home. As a credit research analyst for Blue Hill Asset Management (BHAM), Thomas was a part of the hedge fund's high-yield team and was responsible for identifying “mispricings” in the credit market. He had joined the firm just six months earlier after graduating from his MBA program and had put in many long hours as he acclimated himself with the firm and his role. BHAM was a hedge fund that focused on fundamental relative value strategies. Its strategies were aimed at taking advantage of relative pricing discrepancies between similar securities or derivatives relative to the underlying security. BHAM combined quantitative, technical, and fundamental techniques to identify these strategies. Earlier that day, one of the senior portfolio managers had come by Thomas's desk after receiving a phone call from an investment bank. The investment bank was in the process of building a book for a private offering of senior secured notes by AMR Corporation (AMR), the parent company of American Airlines. It had called BHAM to gauge its interest. The portfolio manager had declined, but was intrigued about identifying potential strategies regarding the AMR credit. As a potential investment, AMR was an interesting high-yield opportunity, since American Airlines was the only major U.S. airline not to have filed for bankruptcy, which left it with a higher debt burden and labor costs than its competitors. The portfolio manager mentioned to Thomas that he was especially interested in trying to identify opportunities in credit derivatives, as this market tended to have better liquidity than the bond market. . . .

Pricing credit default swaps under a multi-scale stochastic volatility model

Abstract In this paper, we consider the pricing of credit default swaps (CDSs) with the reference asset driven by a geometric Brownian motion with a multi-scale stochastic volatility (SV), which is a two-factor volatility process with one factor controlling the fast time scale and the other representing the slow time scale. A key feature of the current methodology is to establish an equivalence relationship between the CDS and the down-and-out binary option through the discussion of “no default” probability, while balancing the two SV processes with the perturbation method. An approximate but closed-form pricing formula for the CDS contract is finally obtained, whose accuracy is in the order of O ( ϵ + δ + ϵ δ ) .

Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Game Changer? The Impact of the VW Emission Cheating Scandal on the Co-Integration of Large Automakerss Securities

This paper investigates the potential change in the securities market pricing behavior of 16 large, global automakers following disclosure of the Volkswagen emission cheating scandal. The triggering public disclosure occurred on September 18, 2015, when the EPA issued a notice of violation to VW, stating that VW had intentionally circumvented the US clean air rules for diesel car emissions. The EPA notice unleashed a torrent of responses and disclosures by the company, regulators, investigators, stakeholders, and others. We first examine and contend that this event may have unblocked what economists call an informational cascade, in that much of the information on VW diesel car emissions was already known to interested parties, yet no significant market response occurred until the September 18 EPA notice. Second, we predict and find a significant change around this event in the stochastic evolution of equity and credit default swap prices in the automobile industry. In the post-emission-cheating-scandal period, this change is consistent with increased market co-integration. A test of economic significance further supports this finding by showing a decrease in the profitability of a hypothetical arbitrage trading rule based on lead-lag pricing relations in the equity and CDS markets.