Credit Default Swap Prices Research Articles

Flexing the default barrier

The paper introduces a Black–Cox-type structural model for credit default swaps (CDS). The existing literature on structural CDS pricing is extended by allowing a general functional form for the default barrier specified without reference to asset volatilities, dividend yields or interest rates. We develop a fast and robust algorithm to compute survival probabilities numerically. An empirical application suggests that the market-implied barrier is stable over time, with a possibly hump-shaped term structure. The implied barrier can be used for computing survival probabilities consistent with objective expectations of asset evolution, for pricing under counterparty risk, and for determining optimal corporate bond covenants.

The chicken or the egg? A note on the dynamic interrelation between government bond spreads and credit default swaps

This note provides the first empirical assessment of the dynamic interrelation between government bond spreads and their associated credit default swaps (CDS). We use data for the Southern European countries (Greece, Italy, Portugal and Spain) that found themselves with a problematic public sector in the dawn of the recent financial distress. We find that CDS prices Granger-cause government bond spreads after the eruption of the 2007 sub-prime crisis. Feedback causality is detected during periods of financial and economic turmoil, thereby indicating that high risk aversion tends to perplex the transmission mechanism between CDS prices and government bond spreads.

Credit Modelling Under Jump Diffusions with Exponentially Distributed Jumps - Stable Calibration, Dynamics and Gap Risk

This paper introduces a structural credit default model that is based on a hyper-exponential jump diffusion process for the value of the firm. For credit default swap prices and other quantities of interest, explicit expressions for the corresponding Laplace transforms are derived. As an application of our findings, the model is calibrated to market quotes of fair credit default swap spreads. The time-dynamics of the model are studied, particularly the jumps in credit spreads, the understanding of which is crucial for the valuation of options on credit default swaps such as gap options.

‘Extended black’ sovereign credit default swap pricing model

This article presents and tests an ‘Extended Black’ sovereign Credit Default Swap (CDS) pricing model, whereby the default intensity is driven by truncated Gaussian latent factors. CDS pricing requires numerical solutions through finite differences, yet maximum likelihood estimation is still feasible. Empirical evidence from sovereign CDS rates supports the Extended Black model. The addition of a second truncated Gaussian latent factor driving the default intensity significantly improves performance.

Empirical analysis and calibration of the CEV process for pricing equity default swaps

Equity Default Swaps (EDSs) are credit-like instruments that were first introduced in 2003. EDSs are deep out of the money digital put options that pay out a fixed amount (recovery rate) upon the stock price hitting a pre-set low barrier. The premium is paid out as contingent quarterly payments similar to Credit Default Swaps (CDSs). EDSs initially soared in volume as investors used them in capital structure arbitrage strategies involving the simultaneous buying and selling of EDS contracts, as spreads on EDSs were several multiples of CDS spreads. However, the contracts diminished in volume as CDS contracts took over. With the recent financial turmoil in the credit derivatives market, some attention has turned from CDS and their associated structured correlation products such as Nth-to-default basket and synthetic Collateralized Debt Obligations (CDOs) as CDS markets tend to be opaque and difficult to price. In addition, default correlations are not directly observable and recoveries are stochastic, making pricing and modelling difficult. As against this, the underlying stock prices in EDS are directly observable and the correlation is also directly observable. The EDS may therefore return to the credit fold and may be a complement to the CDS market. In this paper, we examine the pricing of CDSs using the CEV process and calibrate the CEV process to actual observed market prices for EDS; we then draw conclusions on the CEV process, the relationship between stock prices and volatility, and the relationship between CDS and EDS prices.

The BP Oil Disaster: Stock and Option Market Reactions

The BP Deepwater Horizon drilling rig exploded on April 20, 2010, leading to an unprecedented environmental and financial disaster. This paper details responses in the financial markets for BP securities, including stock, bonds, options, and credit default swaps. Following the disaster BP shares dropped more than 50 percent in value, with high volatility. BP share trading volume increased thirteen-fold, and option trading volume increased twenty-fold. The implied volatility of BP shares also jumped, ranging between two and four times its earlier levels. Interest rate spreads on BP bonds widened and the prices of credit default swaps exploded. Finally, on June 16, the company announced that cash dividends were suspended. We provide evidence from options markets that this dividend suspension was anticipated. From late June through September, there was a partial reversion to pre-explosion levels in all markets. We detail the degree of integration across markets, as wide swings in BP’s outlook were simultaneously absorbed in the various markets.

Fast Valuation and Calibration of Credit Default Swaps Under Levy Dynamics

In this paper we address the issue of finding an efficient and flexible numerical approach for calculating survival/default probabilities and pricing Credit Default Swaps under advanced jump dynamics. We have chosen to use the firm's value approach, modeling the firm's value by an exponential\levy\model. For this approach the default event is defined as a first passage of a barrier and it is therefore possible to exploit a numerical technique developed to price barrier options under\levy\models to calculate the default probabilities. The method presented is based on the Fourier-cosine series expansion of the underlying model's density function.With this method we calibrate two well known\levy\models, the Normal Inverse Gaussian and the CGMY, to the market quotes of the iTraxx Series 7 and 8 constituents. In the calibration study we look at the root mean square error of the fit and find that both models give a very good fit to market data. Furthermore, we investigate how the out of calibration given parameters evolve over the year covered by the two series. Finally, we look at the changes in the default probability term structure over the year.

Types of Liquidity and Limits to Arbitrage - The Case of Credit Default Swaps

Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period 6/2008 to 9/2009, we show that funding-liquidity (shadow cost of capital for arbitrageurs) as well as asset specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these two types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding period of 127 days, but the path to convergence is not smooth.

A New Capital Requirement for Large Financial Institutions

We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.

Credit Risk Pricing in Emerging Markets During Elections: Time Inconsistency and Forward Looking Uncertainty

To study the role of elections in financial market instability, we focus on the role of credit risk pricing during elections from 2004 to 2007 in thirteen emerging market economies. We use a unique dataset of daily credit default swap (CDS) pricing, with standard macroeconomic controls, to study the role of elections in prompting financial market instability and contagion. Sovereign credit default swap pricing provides a number of advantages in understanding emerging market instability of previous studies. First, the daily data allows a greater level of specificity than was used in previous credit and political studies. Second, even though sovereign credit conditions change slowly, CDS pricing changes daily, reflecting sentiment or forward looking beliefs. Third, the CDS allows us to focus on the perceived credit risk of an election and the incoming government. Our study reveals a number of unique findings. First, investors price in additional risk for elections regardless of party, incumbency, or size of win. Second, long and short term investors price risk very differently, with 1 year CDS investors reacting much more strongly to election risk, causing the overall spread to narrow. Third, our results provide continued support for the theory of investor herding in international financial markets, and a focus on a small number of economic variables in determining sovereign credit worthiness. Investors do not study the relative risk factors as much as price in structural risk by the existence of definable benchmarks like elections.

Local Volatility Enhanced by a Jump to Default

A local volatility model is enhanced by the possibility of a single jump to default. The jump has a hazard rate that is the product of the stock price raised to a prespecified negative power and a deterministic function of time. The empirical work uses a power of $-1.5$. It is shown how one may simultaneously recover from the prices of credit default swap contracts and equity option prices both the deterministic component of the hazard rate function and revised local volatility. The procedure is implemented on prices of credit default swaps and equity options for General Motors and the Ford Motor Company over the period October 2004 to September 2007.

Local Volatility Enhanced by a Jump to Default

A local volatility model is enhanced by the possibility of a single jump to default. The jump has a hazard rate that is the product of the stock price raised to a prespecified negative power and a deterministic function of time. The empirical work uses a power of -1.5. It is shown how one may simultaneously recover from the prices of credit default swap contracts and equity option prices both the deterministic component of the hazard rate function and revised local volatility. The procedure is implemented on prices of credit default swaps and equity options for GM and FORD over the period October 2004 to September 2007.

A New Capital Regulation for Large Financial Institutions

We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt.

The Impact of Earnings on the Pricing of Credit Default Swaps

ABSTRACT: This study evaluates the impact of earnings on credit risk in the Credit Default Swap (CDS) market using levels, changes, and event study analyses. We find that earnings (cash flows, accruals) of reference firms are negatively and significantly correlated with the level of CDS premia, consistent with earnings (cash flows, accruals) conveying information about default risk. Based on the changes analysis, a 1 percent increase in ROA decreases CDS rates significantly by about 5 percent. We also find that (1) CDS premia are more highly correlated with below-median earnings than with above-median earnings and (2) CDS premia are more highly correlated with earnings of low-rated firms than with earnings of high-rated firms. Evidence indicates further that short-window earnings surprises are negatively and significantly correlated with CDS premia changes in the three-day window surrounding the preliminary earnings announcement, although the impact is concentrated in the shorter maturities.

A New Capital Regulation for Large Financial Institutions

We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.

Pricing constant maturity credit default swaps under jump

In this paper we discuss the pricing of constant-maturity credit default swaps under single-sided jump models. The constant-maturity credit default swap offers default protection in exchange for a floating premium that is periodically reset and indexed to the market spread on a credit default swap with constant-maturity tenor written on the same reference name.By setting up a firm's value model based on single-sided Lévy models we can generate dynamic spreads for the reference credit default swap. The valuation of the constant-maturity credit default swap can then easily be done by Monte Carlo simulation.

Credit Default Swaps and Stock Prices: Further Evidence within and Across Markets from Mean and Volatility Transmission with a MVGARCH-M Model and Newer Data

The goal of this paper is to investigate empirically the association between the stock market and the credit default swap (CDS) market in terms of mean as well as volatility spillovers. Making use of 1612 daily observations from four stock markets, i.e., US, German, UK and Greek markets, as well as from two European CDS indices along with the methodology of the error correction (EC) and the multivariable generalized heteroskedasticity in mean (MVGARCH-M) modelling, the empirical findings yield: stock returns across European and US markets are negatively related to European CDS spread changes, the CDS market seems to lead the stock market, implying that information contents coming from the firm's environment seems first to have an impact on the CDS market and next to the stock market, and stock market volatility exerts a positive impact on CDS spreads.

Liquidity Premia in the Credit Default Swap and Corporate Bond Markets

This paper employs a new approach to estimating the size of liquidity premia in the credit default swap (CDS) and corporate bond markets. We develop a CDS pricing model with liquidity and default, and a corporate bond pricing model with default, taxes, and liquidity using the reduced-form approach, and jointly estimate parameters of both pricing models from pooled data using the generalized method of moments. By formulating default intensity as a common factor of the spreads of the CDS and reference bonds, we are able to identify the liquidity and other components of spreads more precisely. We find that both CDS and corporate bond spreads contain significant liquidity components. On average, the liquidity premium accounts for 13% of the CDS spread and 23% of the corporate yield spread. The size of the liquidity premium increases as the rating decreases. Estimates of liquidity premia in the CDS and corporate bond markets are highly correlated, and closely linked to bond-specific and aggregate liquidity measures. Results show that liquidity is important for CDS and corporate bond pricing. Ignoring CDS illiquidity results in a significant bias in estimation of corporate yield spread components when using the CDS information to aid in decomposition of spreads.

SOX, Corporate Transparency, and the Cost of Debt

We investigate the impact of the Sarbanes-Oxley (SOX) Act on the cost of debt through its effect on the reliability of financial reporting. Using Credit Default Swap (CDS) spreads and a structural CDS pricing model, we calibrate a firm-level corporate opacity parameter in the pre- and post-SOX periods. Our analysis shows that corporate opacity and the cost of debt decrease significantly after SOX. The median firm in our sample experiences an 18 bp reduction on its five-year CDS spread as a result of lower opacity following SOX, amounting to total annual savings of $ 844 million for the 252 firms in our sample. Furthermore, the reduction in opacity tends to be larger for firms that in the pre-SOX period have lower accrual quality, less conservative earnings, lower number of independent directors, lower S&P Transparency and Disclosure ratings, and are more likely to benefit from SOX-compliance according to Chhaochharia and Grinstein’s (2007) criteria.

Pricing and trading credit default swaps in a hazard process model

In the paper we study dynamics of the arbitrage prices of credit default swaps within a hazard process model of credit risk. We derive these dynamics without postulating that the immersion property is satisfied between some relevant filtrations. These results are then applied so to study the problem of replication of general defaultable claims, including some basket claims, by means of dynamic trading of credit default swaps.