Credit Default Swap Spreads Research Articles

Implementing a European Bail-In Regime: Do BRRD & SRM-R Effectively Eliminate Implicit Government Guarantees in the European Banking Sector? An Empirical Analysis

During the last decade, policymakers have implemented a European bank resolution regime, which includes the Bank Recovery & Resolution Directive and the Single Resolution Mechanism Regulation, designed to make banks resolvable and to abolish bailout expectations, i.e. implicit government guarantees (IGGs). The regime strives to make banks’ debt bail-in-able and to make government bailouts of banks the rare exception. The overall research objective of this paper is to measure the effectiveness of this regime in terms of bailout expectations in the form of funding advantages. Specifically, we examine market reactions to regime implementation, using an event- study framework to quantify the impact of key legal events on credit default swap (CDS) spreads and equity returns. We control for a wide range of variables to address endogeneity concerns raised with regard to omitted variables in prior work. Our uni-variate and multivariate analysis results suggest that the European bail-in regime alone does not effectively eliminate IGGs. On the contrary, CDS spreads, especially among global systemically important banks, are tightening and equity returns are increasing. This indicates that the regime inadequately solves the systemic problem of bailout expectations in the market.

Funding liquidity shocks in a quasi-experiment: Evidence from the CDS Big Bang

We use the advent of new credit default swap (CDS) trading conventions in April 2009—the CDS Big Bang—to study how a shock to funding liquidity impacts market liquidity. After the Big Bang, traders are required to pay upfront fees to execute CDS transactions, with the size of the fees depending on the level of CDS spreads. While CDS bid-ask spreads decline in aggregate after the Big Bang, they do so less for contracts that require larger fees. Furthermore, the funding effect is stronger for smaller and riskier firms and for noncentrally cleared contracts. The effect also becomes stronger after Deutsche Bank's exit.

Inflated Credit Ratings, Regulatory Arbitrage and Capital Requirements: Do Investors Strategically Allocate Bond Portfolios?

This study investigates whether banks and insurance corporations perform regulatory arbitrage by buying bonds with inflated credit ratings. We argue that credit rating based capital requirements incentivize banks and insurance corporations to hold more bonds with inflated credit ratings. We estimate the probability of a bond having an inflated credit rating using conditional credit default swap spread distributions and merge this with a unique bond-level portfolio holdings dataset. The results show that banks and insurance corporations invest more in bonds with inflated credit ratings, while this effect is absent for investors who do not face capital requirements based on credit ratings. Predominantly, banks and insurance corporations hoard systemic risk not penalized in capital regulation, as they are especially inclined to hold bonds with inflated credit ratings that carry substantial systemic risk. Consequently, the required capital buffers of banks and insurance corporations are effectively reduced by respectively 9 and 20 percent.

CDS-based implied probability of default estimation

PurposeThis study aims to shed more light on the relationship between probability of default, investment horizons and rating classes to make decision-making processes more efficient.Design/methodology/approachBased on credit default swaps (CDS) spreads, a methodology is implemented to determine the implied default probability and the implied rating, and then to estimate the term structure of the market-implied default probability and the transition matrix of implied rating. The term structure estimation in discrete time is conducted with the Nelson and Siegel model and in continuous time with the Vasicek model. The assessment of the transition matrix is performed using the homogeneous Markov model.FindingsThe results show that the CDS-based implied ratings are lower than those based on Thomson Reuters approach, which can partially be explained by the fact that the real-world probabilities are smaller than those founded on a risk-neutral framework. Moreover, investment and sub-investment grade companies exhibit different risk profiles with respect of the investment horizons.Originality/valueThe originality of this study consists in determining the implied rating based on CDS spreads and to detect the difference between implied market rating and the Thomson Reuters StarMine rating. The results can be used to analyze credit risk assessments and examine issues related to the Thomson Reuters StarMine credit risk model.

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.

The Role of Redenomination Risk in the Price Evolution of Italian Banks’ CDS Spreads

The recent financial crisis offered an interesting opportunity to analyze the markets’ behavior in a high-volatility framework. In this paper, we analyzed the price discovery process of the Italian banks’ Credit Default Swap (CDS) spreads through the Merton model, extended with the inclusion of a redenomination risk proxy, as to say, the risk that Italy could leave the eurozone. This paper contributes to the literature by integrating the classic Merton model with a political-sensitive market variable able to explain the greatest variance in the Italian banks’ CDS spreads during the most relevant and commonly recognized periods of socio-political and financial distress. Results show that the redenomination risk is progressively becoming the main driver of the process during crises, in particular for the sovereign debt crisis and in 2018.

Do Markets Value ESG Risks in Sovereign Credit Curves?

This paper investigates the role of countries' environmental, social and governance (ESG) performance in sovereign CDS markets. Based on data for 60 countries from 2007 to 2017, we find that countries with superior ESG performance do not only show lower credit default swap (CDS) spreads, they also exhibit flatter CDS implied credit curves. This implies a risk mitigation effect of ESG which is even more pronounced in the long term than in the short term. These results remain robust with regard to various economic and financial control variables as well as credit ratings, implying that CDS markets incorporate ESG information differently than credit rating agencies. From an investor's perspective, we find that considering ESG does not involve sacrificing returns. Indeed, investors can potentially benefit from ESG differences between countries with similar credit ratings.

The Impact of COVID-19 on Supply Chain Credit Risk

Global supply chains expose firms to multi-regional risks while also providing a buffer against local shocks. The recent COVID-19 pandemic and its differential impact on different regions in the world provide an opportunity to explore these effects. We examine multi-regional supply chain risk by focusing on credit risk as measured by CDS spreads and US-China supply chain networks. We find that local risks propagate through global supply chains to other regions. CDS spreads for firms with Chinese supply chain partners increase by 8-9 percent due to supply chain disruptions during the pandemic-related economic shutdown period in China, and the spreads decrease by 12-20 percent when the supply chain activities resume during the economic re-opening period. The household demand channel plays an important role in this risk propagation. We find that supply chain activity resumption is insufficient to decrease credit risk in sectors that cater to local households when the local economy suffers from dampened household spending due to economic shutdowns. Having a more global customer base mitigates the local household demand shock effects. Firm leverage and supply chain duration weaken supply chain resilience as reflected in credit risk during the pandemic, whereas supply chain network centrality, cash holdings, growth opportunities, and strong credit ratings increase resilience in global supply chains.

Owe a Bank Millions, the Bank Has a Problem: Credit Concentration in Bad Times

How does a bank react when a substantial share of its borrowers suffer a large negative shock? To answer this question we exploit the 2014 collapse of energy prices using the universe of Mexican commercial bank loans. We show that, after the drop in energy prices, banks exposed to the energy sector increased their exposure to these borrowers even more, relaxing credit margins to their larger debtors in the sector. An increase of one standard deviation in a bank's ex-ante exposure to the energy sector increased the loan volume to borrowers in the sector by 18 percent and reduced interest rates by 6 percent, even though borrower's credit default swap spreads were widening. Highly exposed banks amplified this sector-specific shock to the rest of the economy by contracting lending to other sectors, with important real effects, as the borrowers could not switch credit suppliers. Finally, the energy price shock had a large negative impact on macro outcomes, especially in the capital-intensive secondary sector. Quantitatively, a one standard deviation increase in the exposure of a state's banks to the energy sector reduced its GDP by 1.8 percent.

Analysing the link between environmental performance and sovereign credit risk

ABSTRACT This study investigates the effects of a country’s environmental performance on sovereign credit risk. We use sovereign credit default swap (CDS) spreads for a large panel of countries to analyse whether the relationship between environmental performance and credit risk varies by the maturity of the credit instrument and by the level of fiscal performance. Using a dynamic panel generalized method of moments model, we document a negative association between environmental performance and credit risk. This relationship does not exhibit substantial variation by CDS maturity.

A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

In this article, a risk-adjusted return on capital (RAROC) valuation scheme for loans is derived. The critical assumption throughout the article is that no market information on a borrower’s credit quality like bond or CDS (Credit Default Swap) spreads is available. Therefore, market-based approaches are not applicable, and an alternative combining market and statistical information is needed. The valuation scheme aims to derive the individual cost components of a loan which facilitates the allocation to a bank’s operational units. After its introduction, a theoretical analysis of the scheme linking the level of interest rates and borrower default probabilities shows that a bank should only originate a loan, when the interest rate a borrower is willing to accept is inside the profitability range for this client. This range depends on a bank’s internal profitability target and is always a finite interval only or could even be empty if a borrower’s credit quality is too low. Aside from analyzing the theoretical properties of the scheme, we show how it can be directly applied in the daily loan origination process of a bank.

Market price effects of agency sovereign debt announcements: Importance of prior credit states

This paper investigates the price response to credit rating agency (CRA) announcements on sovereign bonds. We characterize credit rating events controlling announcements for the prior credit state – outlook, watch/review, or stable status as well as the level of the credit rating. Emphasizing the transition from one state to another allows us to distinguish between different types of announcement (rating changes, watch and outlook events) and their price effects. We also investigate whether price responses have diminished since the Global Financial Crisis (GFC). We employ an event study methodology and gauge market response by standardized cumulative abnormal returns (SCAR) and directional change statistics in daily credit default swap (CDS) spreads. We find that rating announcements provide a rich and varied set of information on how credit rating agencies influence market perceptions of sovereign default risk. CRA announcements continued to have significant effects on CDS spreads after the GFC, but the magnitude of the responses generally fell. Moreover, we find that accurate measurement of these effects depends on conditioning for the prior credit state of the sovereign bond.

The cross-country transmission of credit risk between sovereigns and firms in Asia

This paper uses Credit Default Swap (CDS) data for Asian reference entities to examine cross-country credit risk spillover effects between sovereigns and firms. Data for three East Asian countries (China, Japan and South Korea) over the period 2009–2018 are analysed. We analyse changes in the CDS spreads of a sovereign debtor and those of a foreign firm via a bivariate GARCH-full-BEKK model; thus, spillovers in mean spread changes as well as in volatility are considered. The main findings indicate that strong credit risk interdependence exists between the East Asian countries given that credit shocks from a common creditor such as Japan appear to spill over to the other two Asian nations. Compared to their non-financial counterparts, financial institutions are more sensitive than non-financial firms to changes in the credit risk of a foreign sovereign debtor; financial institutions such as banks may hold debt of foreign sovereigns which makes their CDSs sensitive to this source of credit risk.

Reserves and Risk: Evidence from China

We consider if the Chinese accumulation of reserves is associated with unintended consequences in the form of increased private sector risk taking. Using sovereign credit default swap spreads and stock index prices as indicators of risk taking, we provide evidence to suggest that as reserve holdings increase, so does the willingness of the private sector to take on more risk. This is an important finding that adds credence to the suggestion that insurance through costly reserves, to be used in the event of a crisis, may lead to private sector actions that in and of themselves make it more likely that this insurance will be used.

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.

Anatomy of a Sovereign Debt Crisis: Machine Learning, Real-time Macro Fundamentals, and CDS Spreads

We study the time-varying dependence of sovereign credit default swap (CDS) spreads on real-time, country-specific macro indicators during the eurozone sovereign debt crisis. Macro fundamentals explain 66% of the time-series variance of CDS spreads, but the time variation in macro sensitivities is also important, explaining close to 30% of the variance. Hence, while CDS spreads reflect macro fundamentals, they also display volatility unrelated to fundamentals. We identify distinct regimes of variation, consistent with a multiple-equilibrium view of the sovereign debt markets. Our estimated macro sensitivities predict the VSTOXX European equity volatility index out of sample.

A New Indicator of Bank Funding Cost

The cost of bank funding on money markets is typically the sum of a risk-free rate and a spread that reflects rollover risk, i.e., the risk that banks cannot roll over their short-term market funding. This risk is a major concern for policymakers, who need to intervene to prevent the funding liquidity freeze from triggering the bankruptcy of solvent financial institutions. We construct a new indicator of rollover risk for banks, which we have called forward funding spread. It is calculated as the difference between the three-month forward rate of the yield curve constructed using only instruments with a three-month tenor and the corresponding forward rate of the default-free overnight interest swap yield curve. The forward funding spread usefully complements its spot equivalent, the IBOR-OIS spread, in the monitoring of bank funding risk in real time. First, it accounts for the market participants' expectations for how funding costs will evolve over time. Second, it identifies liquidity regimes, which coincide with the levels of excess liquidity supplied by central banks. Third, it has much higher predictive power for economic growth and bank lending in the United States and the euro area than the spot IBOR-OIS, credit default swap spreads or bank bond credit spreads.

Modeling CDS spreads: A comparison of some hybrid approaches

Abstract According to the credit risk model proposed by Cathcart and El-Jahel (2006), default can occur either expectedly, when a certain signaling variable breaches a lower barrier, or unexpectedly, as the first jump of a Poisson process, whose intensity depends on the signaling variable itself and on the interest rate. In the present paper we test the performances of such a model and of other three models generalized by it in fitting the term structure of credit default swap (CDS) spreads. In order to do so, we derive a semi-analytical formula for pricing CDSs and we use it to fit the observed term structures of 65 different CDSs. The analysis reveals that all the model parameters yield a relevant contribution to credit spreads. Moreover, if the dependence of the default intensity on both the signaling variable and the interest rate is removed, the pricing of CDSs becomes very simple, from both the analytical and the computational standpoint, while the goodness-of-fit is reduced by only a few percentage points. Therefore, when using the credit risk model proposed by Cathcart and El-Jahel (2006), assuming a constant default intensity provides an interesting and efficient compromise between parsimony and goodness-of-fit. Furthermore, by fitting the term structure of CDS spreads on a period of about twelve years, we find that the parameters of the model with constant default are rather stable over time, and the goodness-of-fit is maintained high.

Information Imprecision

ABSTRACT This study develops and applies a model-implied measure of information imprecision. We define information imprecision as the degree of noise in investors' prior beliefs about the firm's asset value based on the information set that is currently available. We present a model of credit default swap (CDS) spreads in which the term structure is a function of information imprecision. We exploit observable CDS spreads with short and long maturities to extract an empirical measure of information imprecision. We then examine the moderating role of our measure in two settings. First, we show that the equity market response to credit rating changes increases in the level of information imprecision before the announcement. Second, we show that bond-market professionals' ability to charge a premium to smaller investors, relative to larger investors, increases in the issuing firm's information imprecision. This evidence illustrates the broad applicability of our model-implied measure of information imprecision. JEL Classifications: D82; G14; G24.