Credit Derivatives Market Research Articles

Informationally advantaged lenders and the credit derivative market: Evidence from Loan only Credit Default Swap (LCDX)

This paper explores the informational role of the Loan Only Credit Default Index (LCDX) on the pricing of syndicated loans. Despite an extensive body of research on credit indices and loan pricing, limited studies have comprehensively assessed the complex relationship between the LCDX and individual loan spreads. Contrary to indices like the CDX, which are largely linked to corporate bonds, the LCDX directly pertains to the syndicated secured loan market, offering valuable insights about the overall credit default market and the cost of credit risk insurance. Preliminary results reveal a pronounced positive correlation between the LCDX spread and the syndicated loan spread, particularly noticeable amongst borrowers with lower credit quality. The paper highlights the LCDX's pivotal role in conveying secondary credit market information, with critical implications for credit risk management and financial regulations.

Internet Searches, Household Sentiment, and Credit Spreads

We use Google internet search volumes to measure households’ pessimism about overall market-wide credit health in the economy and show that this “household default sentiment” is positively correlated with the credit default swap (CDS) spread level in the market. However, while household default sentiment might drive the cost of credit to some degree, either directly or indirectly through its effect on the stock market, we find the stock market’s opinion about the credit risk in the economy (default probabilities backed out from structural models) to be much more important in explaining credit spreads. The rather weak link between household sentiment and CDS spreads, meanwhile, is consistent with the almost complete absence of retail investors (households) in the institutional investor-dominated credit derivatives market. The results are essentially the same, whether we look at market-wide CDS indexes or single-name CDS contracts, and whether we exclude the financial crisis or not.

Quantitative Structural Models to Assess Credit Risk on Individuals

Default Probabilities quantitatively measures the credit risk that a borrower will be unable or unwilling to repay its debt. An accurate model to estimate, as a function of time, these default probabilities is of crucial importance in the credit derivatives market. In this work, we adapt Merton’s [1] original works on credit risk, consumption and portfolio rules to model an individual wealth scenario, and apply it to compute this individual default probabilities. Using our model, we also compute the time depending individual default intensities, recovery rates, hazard rate and risk premiums. Hence, as a straight-forward application, our model can be used as novel way to measure the credit risk of individuals.

Russian stock market: The practice of using credit derivatives

Subject. This article explores the practice of using credit derivatives in the Russian stock market. Objectives. The article aims to identify the problems and advantages of the Russian credit derivatives market, and propose certain improvements concerning this derivatives market segment. Methods. For the study, we used analysis, comparison, and statistical methods. Results. The article describes the problems and advantages of using credit derivatives in the Russian stock market and proposes certain activities to improve this segment of the market. Conclusions. The results obtained can be used by students and university staff to study over-the-counter derivatives. The proposed measures to improve the credit derivatives market can also be applied for practical purposes to improve the legislative framework and develop the market infrastructure.

A measure of Turkey's sovereign and banking sector credit risk: Asset swap spreads

The existence of the credit derivatives written on the eurobonds such as credit default swaps or asset swaps allows policymakers and investors to monitor the evolvement of credit risk. However, these instruments are mostly available in advanced economies, whereas the market for credit derivatives in emerging market countries, including Turkey, is limited in terms of liquidity and maturity. In this regard, this study aims to construct a proxy for the credit risk of the Turkish Treasury and banking sector in international markets by calculating asset swap spread for US dollar-denominated fixed coupon eurobonds, which requires a robust estimation of the relevant yield curves. The study firstly presents the estimation of the sovereign and banking sector yield curves and then constructs a synthetic asset swap structure to obtain embedded credit risk premia in the eurobond curves. Our findings show that the proposed credit risk indicator is vastly correlated with credit default swap premium. In addition to this, estimated eurobond curves are also useful for monitoring borrowing cost dynamics of the Turkish Treasury and banking sector in international markets.

The Financial Crisis – Risk Transfer, Insurance Layers, and (No?) Reinsurance Culture

The financial crisis of 2007 has triggered various debates, ranging from the stability of the banking system to subtle technical issues regarding the Gaussian and other copulas. All these debates are important, and it might be good to start even a further one: Credit derivatives have much in common with treaty reinsurance, e.g. risk transfer via pooling and layering, scarce data, skewed distributions, and a limited number of specialized players in the market. All this leads to a very particular mixture of mathematical/statistical and behavioral challenges. Reinsurers have been struggling to cope with these, not always successfully, but they have learnt many lessons during their more-than-one century in business. This has led to certain rules adopted by the reinsurance market and to a certain mindset adopted by the individuals working in the industry. Some of the traditions established in the insurance and reinsurance world could possibly inspire markets like the credit derivatives market.

Parsimonious Credit Risk Pricing Model for Corporate Bonds and Credit Derivatives Markets

Parsimonious Credit Risk Pricing Model for Corporate Bonds and Credit Derivatives Markets

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.

Financial derivatives and default dependence: a time-varying copula approach

ABSTRACT The fast development of financial derivatives links financial institutions more closely. In this paper, we investigate the joint default dependence among financial institutions and its association with the recent development of financial derivatives. Two interesting findings emerge. First, time-varying default risk dependencies of financial institutions are found during our sample period. Second, the fast growth of derivatives markets contributes to the rising correlated default risk among financial institutions and further leads to an increase in systemic risk. We show that the default correlation spike coincides with the boom in the US credit derivatives market.

Credit derivatives design to facilitate loan purchase agreements in the secondary loan market in Thailand

PurposeThis paper aims to study a strategic decision of banks in Thailand to signal their types to the market and derive the optimal credit derivatives contract to guarantee their loans and credibly signal their quality under different economic determinants, namely, the maximum credit risk investment constraint, opportunity cost and opaqueness of the credit derivative market.Design/methodology/approachContract theory is deployed to derive the expected payoff of different bank types under different economic and financial constraints. Hence, different bank types offer derivatives contracts to signal their loan quality and resell their loans in the secondary loan markets of Thailand.FindingsThe optimal derivatives contract is constructed on a basis of asymmetric information when banks have more private information concerning quality of their loans. A digital credit default swap is an optimal derivatives contract to send credible signal when banks are restricted to the maximum investment constraint. Moreover, profit of banks is reduced, as the optimal derivatives contract is more costly when banks are subjected to positive opportunity cost and opacity of the credit derivatives market. These results depict impact of changes of the maximum credit risk investment constraint on Thai credit derivatives market.Originality/valueThe optimal credit derivatives design that signifies bank types and facilitates loan purchase agreement has not been studied in Thai secondary loan markets before. In addition, this study provides insights of banks' strategic decisions to signal their types and transfer risk to risk buyers in Thai markets.

Análise crítica do papel das inovações financeiras na crise do subprime

Resumo Este artigo tem por objetivo estudar a importância central assumida pelo mercado de derivativos na dinâmica do capitalismo contemporâneo, debruçando-se particularmente sobre o mercado de derivativos de crédito e sua contribuição para a formação e eclosão da crise financeira que abalou os EUA e o mundo em 2007/2008. Esta dimensão está marcada pela forma derivativo, que altera as relações de propriedade, introduz novos agentes e motivações, aumenta a integração financeira entre os agentes e transforma a lógica de precificação dos principais mercados financeiros. Sendo assim, descreve-se a transformação pela qual passou o mercado de crédito imobiliário norte-americano, argumentando-se que tais mudanças ganharam vigor renovado e apenas se completaram com a ascensão e crescimento dos derivativos de crédito (CDS) e dos CDOs sintéticos, que foram fundamentais para a manutenção das taxas baixas de juros sobre as hipotecas, contribuindo assim diretamente para a bolha no mercado imobiliário que culminou na crise econômica.

Volatility spillovers among the U.S. and Asian stock markets: A comparison between the periods of Asian currency crisis and subprime credit crisis

This paper examines the changing nature of volatility spillovers among the U.S. and eight East Asian stock markets between two financial crises: the Asian currency crisis and the U.S. subprime credit crisis. Our empirical results suggest that volatility is not always spilled over from the directly affected markets to surrounding markets in crisis periods. The East Asian markets who directly suffered from the Asian currency crisis are the ones to which volatility is spilled over from other markets during the Asian currency crisis period, whereas uni-directional volatility spillovers from the U.S. market to other markets are observed during both crisis periods. This difference can be explained by a pre-determined hierarchy in which volatility spillovers tend to start from the U.S. market regardless of the geographical origin of the crisis. Furthermore, our results reveal that the markets in three major Asian financial hubs, i.e., Japan, Hong Kong and Singapore, are the markets to which volatility is spilled over uni-directionally from several other countries during the subprime credit crisis period, but not during the Asian currency crisis period. We attribute this difference to crisis-specific (currency or credit crisis), market-specific (credit derivatives market participation and foreign currency reserves), and time-specific (more integrated global market) factors.

Stock return expectations in the credit market

In this paper we compute long-term stock return expectations (across the business cycle) for individual firms using information backed out from the credit derivatives market. Our methodology builds on previous theoretical results in the literature on stock return expectations and, empirically, we demonstrate a close relationship between credit-implied stock return expectations and future realized stock returns. We also find stock portfolios selected based on credit-implied stock return forecasts to beat equally- and value-weighted portfolios of the same stocks out-of-sample. Contrary to many other studies, our expectations/predictions are made at the individual stock level rather than at the portfolio level, and no parameter estimations using historical stock price- or credit spread observations are needed.

Credit Derivatives Market Design, Creating Fairness and Sustainability

Now that the first wave of the financial crisis has been resolved through the coordinated efforts of regulators and banks, it is important to address some of the systematic weaknesses of the current financial system. One such weakness is the inappropriate incentive effects of the market for credit derivatives, and in particular, for credit default swaps. As a risk management tool, credit derivatives were originally an effective means of diversifying lending risk. Credit derivatives have worked to cover exposures where there have been credit events of the underlying reference entities. To date, the global market for derivatives has operated largely without regulatory oversight; yet it is increasingly evident that deficiencies in the market contributed, at least in part, to the liquidity crisis in the financial sector, resulting in massive injection of public funds in numerous jurisdictions. As structural adjustments are being made to ensure long term financial stability, the credit derivative market needs timely, targeted, and effective adjustment, with a measure of regulatory oversight. Credit default swaps (CDS), by far the most common form of credit derivative, are illustrative. There are two critical points at which intervention is required. The first is at the purchase and sale stage, where there is a serious lack of transparency regarding both material adverse risks associated with the reference entity and material risk in respect of the protection seller’s ability to settle the CDS if a credit event occurs. There is also a lack of due diligence and disclosure by those who are recommending CDS products to less sophisticated purchasers. Second, at the point of settlement and restructuring proceedings, there is a threat to current public policy goals of rehabilitating financially distressed businesses where they are viable, given structural and incentive effects for derivatives that are both physically and cash settled. The disconnection between economic interest and legal interest runs contrary to fundamental insolvency law principles adopted by numerous jurisdictions. In this respect, there needs to be a balancing of public law principles, those advancing the goals of insolvency law and those advancing the effective operation of capital markets. At times they align, at others, they are in sharp disaccord. This brief article addresses these two issues, offering ten recommendations for immediate action. More fundamentally, there needs to be public debate regarding the “casino” aspect of the current market for credit derivatives.

Stressed to the core: Counterparty concentrations and systemic losses in CDS markets

U.S. supervisory stress tests to date have focused on the resilience of large banks to withstand the direct effects of credit and trading shocks. Using data from Depository Trust & Clearing Corporation (DTCC), we apply the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) supervisory scenarios to evaluate the default of a bank's largest counterparty. We find that indirect effects of this default, through the bank's other counterparties, may be larger than the direct impact on the bank. Further, when taken as a whole, the core banking system has a higher exposure concentration to a single counterparty than does any individual bank holding company. We find that the U.S. banking system's counterparty exposure concentration has risen over the 2013–2015 period. Under the 2015 CCAR this corresponds to a market diversity with just over three counterparties under stress. Our results are the first to evaluate the U.S. credit derivatives market under stress and underscore the importance of a macroprudential perspective on stress testing.

Stock Prices and Stock Return Volatilities Impliedby the Credit Market

In this article, the author compares equity and credit investors’ opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple “capital structure arbitrage” trading strategies based on past credit-implied prices. These strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. The author demonstrates how an alternative credit-based “fear gauge,” comparable to the CBOE VIX but emanating from the credit market, can be constructed using the credit-implied volatilities. He calls this implied volatility index the Credit-Implied Volatility Index (CIVX). Finally, a plot of the entire term structure of implied volatilities demonstrates a distinct maturity volatility skew.

Stock Prices and Stock Return Volatilities Implied by the Credit Market

In this paper we compare equity- and credit investors’ opinions on the price formation in the equity market. More exactly, we invert the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for the firms in the DJIA index. The creditimplied stock prices often deviate significantly from actual stock prices over the longer term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA index. In an attempt to demonstrate potential applications of credit-implied stock prices we construct simple “capital structure arbitrage” trading strategies based on past credit-implied prices. Our strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. We demonstrate how an alternative credit-based “fear gauge”, comparable to the VIX index but emanating from the credit market, can be constructed using the credit-implied volatilities. We call this implied volatility index the Credit-Implied Volatility Index (CIVX) index. Finally, a plot of the entire term-structure of implied volatilities demonstrates a distinct maturity volatility skew.

Stressed to the Core: Counterparty Concentrations and Systemic Losses in CDS Markets

Supervisory stress testing to date has focused on the resiliency of large banks to withstand the direct effects of a credit shock. Using data from Depository Trust & Clearing Corporation (DTCC), we apply the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) supervisory scenarios to evaluate the default of a bank's largest counterparty. We find that indirect effects of this default, through the bank's other counterparties, are larger than the direct impact on the bank. Further, when taken as a whole, the core banking system has a higher concentration to a single counterparty than does any individual bank holding company. Under the 2015 stress, the banking system's counterparty credit concentration is high and corresponds in diversity to a market with just over three firms. Our results are the first to evaluate the credit derivatives market under stress and also underscore the importance of a macroprudential perspective on stress testing.

Risk Management in the Banking Sector: Case of TRNC

Since 1980’s the concept of risk management entered into the agenda of financial markets and specifically after the introduction of Basel II Accord, has become the core basis in the banking sector. Financial liberalization, increased competition between financial institutions, the development of credit markets, the expansion of the credit derivatives market and the invention of new financial instruments, mainly complicated the management of credit risk for the banks and other integrated risks as a result of these developments. The first step in effective risk management process is to identify the risk exposures of the banks, to measure these risks and to develop methods to control and mitigate these risks. At this stage, Basel Accords and various regulations on risk management set forth by different supervisors are taken into account. In this study, the concept of risk management and its developmental stages until its current framework have been analysed and the implementation phase within TRNC has been examined.

'Materiality' Requirement in Credit Derivatives Fraud Litigations: The Hidden Role of the 'Short-Party'

Since early 2006 until late 2007 when the U.S. housing market began show signs of distress, certain hedge funds and investment banks started to develop complex short-selling strategies based on sophisticated credit derivatives instruments, which enabled them to express a bearish view of systematic spread widening in the U.S. housing market and place unlimited side bets on it. When the U.S. housing market bubble burst, investment banks and hedge funds realized enormous positive returns whilst other investors collectively failed and saw the value of their investments literally vanished away. During the last twelve months, complex synthetic short selling transactions have come under severe scrutiny by the U.S. Securities Exchange Commission (“SEC”). According to the SEC, in the context of such transactions, investment banks made material misrepresentations and omissions to investors, guarantors and portfolio agents by hiding the role and involvement in the asset pool selection process of the “short” party, with economic interest adverse those of long investors. The assessment of the liability of investment banks and certain of their top executive managers responsible for structuring and marketing the synthetic derivative products critically relies on the resolution of the issue of materiality: was the involvement of the short-party in the selection process and its adverse economic interest material? How would a reasonable investor have viewed this information if properly and timely revealed in the context of all facts and circumstances of the case? Would a reasonable investor have acted differently with the benefit of this information under the circumstances of the case? This essay will attempt to answer the aforesaid questions, as follows. Part I will analyze different types of credit derivative products and discuss latest innovations in credit derivatives market. Part II will examine the SEC antifraud enforcement theories and the concept of “materiality” in the context of antifraud provisions. Part III will, then, discuss the materiality of the hidden role of the short-party in the context of three credit derivatives fraud litigations recently brought by the SEC against, respectively, Goldman, Sachs & Co, J.P. Morgan Securities LLC, and Citigroup Global Markets Inc. Lastly, Part IV will address in details potential legal defenses and factual rebuttal on the issue of materiality.