Credit Default Swap Contracts Research Articles

Mutual Fund Holdings of Credit Default Swaps: Liquidity Management and Risk Taking

Using a comprehensive dataset of mutual funds’ quarterly holdings of credit default swap (CDS) contracts during 2007-2011, we analyze the motives for and consequences of mutual funds’ participation in the CDS market pre- and post-financial crisis. Consistent with theoretical work, funds resort to CDS (especially selling) when they face unpredictable liquidity needs and when the CDS securities are liquid, relative to the underlying bonds. Funds also take advantage of the negative basis between CDS and bond yields, especially for the relatively illiquid bonds. Smaller funds follow leading funds in initiating CDS contracts on new reference entities. Moreover, the reference entities that attracted the highest-selling interests from the largest mutual funds are disproportionately firms that were perceived to be “too large to fail” or “too systemic to fail.”

Extreme Liquidity Risk and Credit Default Swap Spreads

We show that extreme liquidity risk is a significant driver of credit default swap (CDS) spreads. We capture the extreme liquidity risk of a CDS contract written on a firm by estimating the tail dependence between the bid-ask spread of the firm's CDS and the liquidity of a CDS market index. Our results show that sellers of credit protection earn a statistically and economically significant premium for bearing the risk of joint extreme downwards movements in the liquidity of individual CDS contracts and the CDS market. This effect holds in various robustness checks and is particularly pronounced during the financial crisis. Finally, we discuss the implications of our findings for insurers and pension funds that enter the CDS market to take on credit risk.

Systemic Risk Management in Financial Networks with Credit Default Swaps

We study insolvency cascades in an interbank system when banks are allowed to insure their loans with credit default swaps (CDS) sold by other banks. We show that, by properly shifting financial exposures from one institution to another, a CDS market can be designed to rewire the network of interbank exposures in a way that makes it more resilient to insolvency cascades. A regulator can use information about the topology of the interbank network to devise a systemic insurance surcharge that is added to the CDS spread. CDS contracts are thus effectively penalized according to how much they contribute to increasing systemic risk. CDS contracts that decrease systemic risk remain untaxed. We simulate this regulated CDS market using an agent-based model (CRISIS macro-financial model) and we demonstrate that it leads to an interbank system that is more resilient to insolvency cascades.

Pricing Sovereign Credit Risk of an Emerging Market

We analyze the market assessment of sovereign credit risk in an emerging market using a reduced-form model to price the credit default swap (CDS) spreads thus enabling us to derive values for the probability of default (PD) and loss given default (LGD) from the quotes of sovereign CDS contracts. We compare different specifications of the models allowing for both fixed and time varying LGD, and we use these values to analyze the sovereign credit risk of Polish debt throughout the period of a global financial crisis. Our results suggest the presence of a low LGD and a relatively high PD for Poland during a recent financial crisis. The highest PD is in the months following collapse of Lehman Brothers. The derived measures of sovereign risk are strongly linked with the level of public debt and with another measure of PD from a structural model. Correlations between our PD values and the CDS spreads heavily depend on the maturity of the sovereign CDS.

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 (CDS). Our study focuses on the complete model space of plausible models covering most of the variables and specifications used elsewhere in the literature, including different copula models. The approach followed supports ultimate transparency and robustness for the empirical study at hand. Using a large data-set 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 almost all essential pricing information making other potential determinants such as Merton-type factors or variables measuring the systematic market evolution - based on simple means or principal component analysis - negligible.

Can the Credit Default Swap Market Be Salvaged? Issues for Borrowers and Investors

Trading volumes in credit default swaps (CDS) have fallen by more than 75% since the 2008 financial crisis to less than $9 trillion notional amount outstanding as of June 2015. This dramatic decline in volumes comes, in part, because of new laws and regulations focused on reducing the risk of these over-the counter (OTC) derivatives products. Despite significant changes in the regulation of these products, there remain a number of defects in the market structure of OTC credit derivatives, flaws which arguably intensified the impact of the 2008 financial crisis and disadvantage both borrowers and investors. These defects in market structure limit competition, make it difficult for investors to understand the risks taken by large universal banks, create the potential for the manipulation of borrower credit spreads, and even affect the recognition of when default events occur under CDS contracts.

Combining hazard rates with the CreditGrades model: A hybrid method to value CDS contracts

In this paper, we propose a hybrid method that combines a hazard rate model with the CreditGrades model to value credit default swap (CDS) contracts. The CreditGrades model is considered an industry benchmark for analyzing credit derivatives. The hybrid method makes use of the default probability generated by the CreditGrades model to determine the hazard rate specific to the bond issuing firm. In this way, the hybrid method is empirically shown to produce better CDS forecast.

Participation and Unbiased Pricing in CDS Settlement Mechanisms

The centralized market for the settlement of credit default swaps (CDS), which governs more than $20 trillion’s worth of outstanding CDS contracts, has been criticized for underpricing the defaulted bonds that underlie the contracts. I take a mechanism design approach to the market for the settlement of CDS contracts and characterize robust settlement mechanisms that deliver unbiased prices for the underlying assets. All robust settlement mechanisms are the payoff equivalent of a posted price mechanism. Because forced participation in the settlement mechanism is not possible, my approach requires the development of a new notion of the core of games of incomplete information. This new notion can be applied to mechanism design environments in which side trades are allowed or when joining the mechanism is a cooperative decision.

Regulation of uncovered sovereign credit default swaps – evidence from the European Union

Purpose – This study aims to analyze the impact and effectiveness of the regulation on the European sovereign Credit Default Swap (CDS) market. The European sovereign debt crisis has drawn considerable attention to the CDS market. CDS have the ability of a speculative instrument to bet against a sovereign default. Therefore, the Regulation (EU) No. 236/2012 was introduced as the worldwide first uncovered CDS regulation. It prohibits buying uncovered sovereign CDS contracts in the European Union (EU). Design/methodology/approach – First, this paper measures spread changes of sovereign CDS of the EU member states around regulation specific event dates to detect whether and when European sovereign CDS reacts to regulation announcements and the enforcement of regulation. Second, it compares the CDS long-term stability of the EU sample with a non-EU sample based on 44 non-EU sovereign CDS entities. Findings – The results indicate widening CDS spreads prior to the regulation, and stable CDS spreads following the introduction of the regulation. In particular, sovereign CDS of European crisis-hit entities are stable since the regulation was introduced. Originality/value – The results show that since the regulation of uncovered CDS in the EU has been enacted, the sovereign CDS market is stable and less volatile. Based on the theory about speculation on uncovered sovereign CDS by betting on the reference entity’s default, the introduction of Regulation (EU) No. 236/2012 appears to be an appropriate measure to stabilize markets and reduce speculation on sovereign defaults.

Lessons From The 2008 Global Financial Crisis: Imprudent Risk Management And Miss Calculated Regulation

Of the major shortcomings exposed during the 2008 global nancial crisis, there are two aspects that have attracted much interest among academics: the under-appreciation of the complexity of new operations at large nancial institutions and the inadequate oversight of basic prudential supervision by regulatory agencies. To provide a brief focus on elements of these aspects, this paper presents correspond- ing case studies involve the fall of two of the largest nance companies ever existed: American International Group and Lehman Brothers Holdings. A survey of related historical arguments shows that while AIG fails due largely to its extended involvement in the new Credit Default Swap contracts that enable gambling on defaults, the collapse of Lehman Brothers' may be attributable to the misguiding capital adequacy regulations implied by the Basel II Accord. Though perhaps overly simplied, the conclusions from these two cases oer insights into the fundamental weaknesses of some primary con- temporary risk management practices and regulations.

Internal Control Quality and Credit Default Swap Spreads

SYNOPSISThis paper presents the first study on the effects of internal control quality on derivatives pricing. Specifically, we utilize data from the credit default swap (CDS) transactions of well-monitored companies to examine the relationship between the quality of internal control and the cost of debt. CDS data are advantageous for the study of this relationship because CDS contracts are comparatively more homogeneous, standardized, and liquid than either bank loans or public bonds. We find that, all else being equal, companies experiencing internal control material weakness (MW) exhibit higher CDS spreads than companies with effective internal control. Moreover, the MW effect on CDS spreads is more pronounced for company-level MWs than for less severe, account-specific MWs. We also document that CDS spreads increase around the filings of MWs. Furthermore, the deterioration of internal control quality is related to increases in CDS spreads. Finally, short-maturity CDS spreads are more affected by MWs than are long-maturity CDS spreads.JEL Classifications: M41; G32; K22.Data Availability: The data are available from public sources.

CVA calculation for CDS under a contagion model with regime-switching intensities

This paper considers the bilateral credit valuation adjustment (CVA) of a credit default swap (CDS) under a contagion model with regime-switching intensities, where the interest rate, the recovery, and the default intensities of the investor, the protection seller and the reference entity are all driven by a continuous-time homogenous Markov chain describing the macro-economy. By using the idea of “change of measure” and some formulas for the Laplace transforms of the cumulated intensities, we obtain the formula for the bilateral CVA of a CDS contract in terms of fundamental matrix solutions of linear, matrix-valued, ordinary differential equations. Based on the results, we perform some numerical experiments to examine how the regime-switching and the default dependence affect the bilateral CVA.

Sovereign Debt Renegotiation and Credit Default Swaps

A credit default swap (CDS) contract provides insurance against default. After a country defaults, the country and its lenders usually negotiate over the share of the defaulted debt to be repaid. This paper incorporates CDS contracts into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower financing costs for the country. Since the CDS payout is not automatically triggered by losses from renegotiations, the lender needs to be compensated for lower expected insurance payments. This leads to higher debt repayment in renegotiation, decreasing the benefits of defaulting, and hence allowing the country to borrow more at lower rates. Uncertainty over the insurance payout when the debt is renegotiated explains why in the data, as the output declines, the CDS spread becomes lower than the bond spread. Furthermore, this pricing dynamic during a debt crisis can be used to infer market perceptions of the probability of the CDS paying out after a renegotiation. The model is calibrated to Greek data, the results show that increasing CDS levels from 0 to 5% of debt lowers the unconditional default probability from 2.6% to 2.0% per year with no impact on debt level. Further increasing the CDS to 40% of debt increases the equilibrium debt level by 15%.

CDS pricing with long memory via fractional Lévy processes

In this paper, we consider spread rates of credit default swaps (CDSs) in a long memory fractional Lévy setting, i.e. where interest and hazard rates are driven by processes whose autocovariance functions decrease very slowly over time. Empirically, this property can be found in many variables like interest and hazard rates, but the usually applied Markovian models are unable to reflect this. Using earlier results on conditional distributions of fractional Lévy processes, we carry out an extensive analysis of parameter sensitivities useful for researchers and practitioners alike and derive an analytical pricing formula for CDS contracts. A first empirical application is provided as well.

Characteristics and development of corporate and sovereign CDS

Purpose– This paper aims to provide an overview of the market for corporate and sovereign credit default swaps (CDS), with particular focus on Europe. It studies whether the subprime crisis of 2007/2008 and, particularly, the European debt crisis 2009/2010 led to a differential development on corporate and sovereign CDS markets and investigates the primary use (speculative risk-trading or risk-hedging) of the two markets in recent years.Design/methodology/approach– The authors use aggregate market data on the size of the respective markets and on the structure of market participants and their changes over time to assess the main research question. They enhance existing data from public sources such as the Bank for International Settlements and Depository Trust and Clearing Corporation with their own statistics on European sovereign CDS and combine their conclusions with observations regarding standardisation efforts and regulatory changes in the CDS market.Findings– The authors show that after the subprime crisis 2007/2008 and the European debt crisis 2009/2010, the corporate and sovereign CDS markets developed quite differently. They provide evidence that since mid-2010, market participants started to use the sovereign CDS market more strongly for speculative purposes than for risk-hedging. This shows both in the shift of risk-quality of sovereign CDS contracts and in the changing structure of market participants. The ongoing standardisation and regulation in the CDS market – leading to further increases in transparency and reductions in transaction costs – may be expected to trigger a similar change also for corporate CDS.Originality/value– Based on a broad variety of market infrastructure data, the authors show a diverging development of corporate and sovereign CDS markets in Europe in recent years. Particularly the sovereign CDS market appears to have shifted from a risk-hedging instrument to being used more strongly for speculative risk-trading. The authors combine their findings with recent regulatory action and market standardisation schemes and draw conclusions for the future development of CDS markets.

Are Credit Default Swaps Credit Default Insurances?

No, they are not. Although they exhibit similar cash flow patterns (economic perspective) this article argues that from a legal, accounting and regulatory perspective credit default swaps (CDS) are not considered to be an insurance contract. The protection buyer of a CDS is eligible to obtain the compensation without suffering any loss (and potentially realizing a gain) whereas insurance policies only pay out to compensate a loss (and not potentially realizing a gain). This disconnect between protection and exposure is the source for potential over-coverage. Furthermore, the concentrated set of reference entities and (interbank) counterparties as well as their tradeability make CDSs highly systemically significant products. Our conclusion is that CDSs are not default insurance policies. We propose to use default protection instead of credit default insurance to avoid the mislabelling. Furthermore, CDS have a substantial systemic risk potential which sharply contrasts to the limited systemic risk in the insurance industry. The legal classification of CDS as insurance contracts would have an enormous impact on the liquidity of CDS, as the ability of counterparties to issue and participate in CDS contracts would be limited.

Credit Default Swaps and Loss Given Default: Has the CDS Market Affected the Recovery Rates of U.S. Corporate Defaults?

We provide the first empirical analysis on the effects of credit default swaps (CDS) on corporate distress resolution with a focus on debt recovery rate. CDS contracts are settled shortly after the occurrence of credit events such as restructuring or bankruptcy filings and, presumably, should cease to be relevant after the settlements. However, we find that the ultimate debt recovery rates, which are determined in the final resolution plan and long after the CDS settlements, are higher for the bankrupt firms with CDS contracts before bankruptcy filings. This CDS effect on recovery rates is more pronounced for bonds than for loans. The overall evidence is consistent with the view that CDS trigger earlier bankruptcy filings, leaving more valuable assets for bondholders in the bankrupt entities.

Securitization and Credit Default Swaps (CDSs): Towards Diagnostic of the Fundamental Problem and Suggested Solutions

Most of the blame for the present Global Financial Crisis (GFC) has been attributed to securitization and CDSs in the years preceding growth of the crisis. On reflection, most of the blame must be “sheeted home” to the former U.S government’s mandate to banks and other financial institutions to mitigate their normal lending criteria on U.S home loans, in case, the voters could be granted home loans when they could otherwise be unable to do so. The fundamental problem with these securitization contracts was not the securitization of good loans, but the securitization of “lemons”. The loans should have never been entered into in the first place. The “failure” of securitization contracts was therefore a failure of well-intended (but poor) government policy makers in foreseeing the unintended consequences. In order to “insure” against expected defaults, the lenders and the investors entered CDS contracts in the shadow banking sector which were cheaper than the conventional loan insurance. The fundamental problem with the CDS contracts which are much touted in the regulated and shadow banking sectors as being “desirable” as a cheaper form of “insurance”, was that they were (and are) able to be used for wagering or betting purposes. In contrast to the conventional insurance contracts, CDS contracts do not require an insurable interest; do not require compliance with the indemnity principle; and are not uberrima fides. Therefore, opportunities for excessive speculation present in asset price bubbles such as GFC and CDSs. But, as Menard Keynes indicated in 1931, while a little bit of speculation does no harm, excessive speculation can result in systemic collapse.

Demand–supply imbalances in the credit default swap market: empirical evidence

This paper empirically examines demand–supply imbalances in the credit default swap (CDS) market and provides evidence of its effect on the CDS spread dynamics. Analysis is conducted on a large and homogenous data set of the 92 non-financial European companies with the most quoted Euro-denominated CDS contracts during the 2002–2008 period. Main findings indicate that short-term CDS price movements, not related to fundamentals, are positively affected by demand–supply imbalances when protection buyers outstrip protection sellers. Results illustrate that CDS spreads reflect not only the price of credit protection, but also a liquidity premium for the anticipated cost of unwinding the position of protection sellers, especially during stress periods.

Demand-Supply Imbalances in the Credit Default Swap Market: Empirical Evidence

This paper empirically examines demand-supply imbalances in the credit default swap (CDS) market and provides evidence of its effect on the CDS spread dynamics. Analysis is conducted on a large and homogenous data set of the 92 non-financial European companies with the most quoted Euro-denominated CDS contracts during the 2002-2008 period. Main findings indicate that short-term CDS price movements, not related to fundamentals, are positively affected by demand-supply imbalances when protection buyers outstrip protection sellers. Results illustrate that CDS spreads reflect not only the price of credit protection, but also a liquidity premium for the anticipated cost of unwinding the position of protection sellers, especially during stress periods.