Credit Default Swap Prices Research Articles

RELATIONSHIP BETWEEN LITHUANIAN SOVEREIGN CREDIT RISK AND EQUITY MARKET

We analyse relationship between Lithuanian sovereign credit risk and equity market. The aim of the paper is to find the impact of the sovereign credit risk, which is expressed in the terms of Credit Default Swaps (CDS), on the movements of stocks prices of Lithuania. We use VAR (vector autoregression) model in order to find the relationship between Lithuanian CDS spread and OMX Vilnius index. We use impulse reaction method to investigate the impact of CDS spreads on the OMX Vilnius index. After analysis of equity index OMX Vilnius and Lithuanian CDS price relationship it was found out that there exists an opposite relationship between these two variables. When the CDS prices are rising, the equity prices decrease and vice versa. The main finding is that Lithuanian capital market returns reacts immediately to the changes of credit risk of Lithuania which is set by the global capital market and expressed by the CDS prices and Lithuanian capital market is under the great foreign pressure.

Credit Derivatives and Earnings Announcements

This paper presents a comprehensive analysis of the role of credit default swaps (CDS) in information production surrounding earnings announcements. First, we demonstrate that the strength of CDS price discovery prior to earnings announcements is related to the presence of private information and the illiquidity of the underlying corporate bonds, consistent with the CDS market being a preferred venue for informed trading. Next, we ask how the information revealed through CDS trading influences the output of equity and credit rating analysts. We find that post-CDS trading, the dispersion and error of earnings-per-share forecasts are generally reduced, and downgrades by both types of analysts become more frequent and more timely before large negative earnings surprises, suggesting that the CDS market conveys information valuable to financial analysts.

CDS pricing and accounting disclosures: Evidence from U.S. bank holding corporations around the recent financial crisis

We investigate what accounting information is important for explaining the credit risk for U.S. bank holding corporations (BHCs) during the recent crisis and find that several CAMELS variables are significantly associated with credit default swap (CDS) spreads. Consistent with industry experience, BHCs with more real estate loans do have higher credit risk as measured by CDS spread. With the newly available finer disclosures for the securities account, we find a positive association between risky assets-backed securities (ABS) and CDS spreads. Our results confirm real estate risk as a major risk for U.S. BHCs during the recent financial crisis. Moreover, our study highlights the importance of distinguishing loans/securities investments by type in understanding the relationship between accounting information and bank credit risk. In addition, we do not find significant association between several accounting-based risk measures and the CDS spread, a forward-looking market-based risk measure.

The economic significance of CDS price discovery

Between 2005 and 2009, we document evident time-varying credit risk price discovery between the equity and credit default swap (CDS) markets for 174 US non-financial investment-grade firms. We test the economic significance of a simple portfolio strategy that utilizes fluctuation in CDS spreads as a trading signal to set stock positions, conditional on the CDS price discovery status of the reference entities. We show that a conditional portfolio strategy which updates the list of CDS-influenced firms over time, yields a substantively larger realized return net of transaction cost over the unconditional strategy. Furthermore, the conditional strategy’s Sharpe ratio outperforms a series of benchmark portfolios over the same trading period, including buy-and-hold, momentum and dividend yield strategies.

Pricing credit default swaps with a random recovery rate by a double inverse Fourier transform

We evaluate the par spread for a single-name credit default swap with a random recovery rate. It is carried out under the framework of a structural default model in which the asset-value process is of infinite activity but finite variation. The recovery rate is assumed to depend on the undershoot of the asset value below the default threshold when default occurs. The key part is to evaluate a generalized expected discounted penalty function, which is a special case of the so-called Gerber–Shiu function in actuarial ruin theory. We first obtain its double Laplace transform in time and in spatial variable, and then implement a numerical Fourier inversion integration. Numerical experiments show that our algorithm gives accurate results within reasonable time and different shapes of spread curve can be obtained.

Illiquidity Contagion and Information Spillover from CDS to Equity Markets

We examine illiquidity spillovers between credit default swap (CDS) and equity markets, proposing that increased CDS illiquidity decreases liquidity provision by equity market makers who use CDS prices as signals of firm value. To motivate this mechanism, we extend a model of insider trading to include a cross-market signal of firm value. Regression analyses confirm significant co-movements between measures of equity illiquidity and lagged measures of CDS price noisiness. This interconnectedness has important implications for equity market quality: when CDS markets become more illiquid, stocks with CDS contracts face greater price impact and higher illiquidity than stocks without CDS traded.

Market frictions and the pricing of sovereign credit default swaps

This paper contributes to the general understanding of how sovereign CDS prices are formed by studying the information content of pricing errors generated by a non-arbitrage model. We implement a price-discrepancy measure in the spirit of the noise measure introduced by Hu et al. (2013) in the Treasury Bond market, and analyze its main determinants in panel data analysis. The main results show that sovereign CDS pricing errors are systematically related to higher bid-ask spreads. The evidence in this paper also suggests that exits of capital arbitrage during distressed periods, as measured by changes in net offsetting, can be associated to larger pricing errors in sovereign CDS from advanced economies, thereby supporting the main claims of the limit-to-arbitrage theories. These findings are robust for the most common CDS pricing models employed in the industry and different estimation techniques.

The Effect of Risk Factor Disclosures on the Pricing of Credit Default Swaps

This study examines whether and how the SEC’s mandate of risk factor disclosures (RFDs) affects the pricing of credit default swaps (CDS). We predict and find that CDS spreads decrease after RFDs are made available in corporate filings. These results suggest that RFDs improve transparency of firms’ financial reporting and reduce information risk premium contained in CDS spreads. Additional analyses suggest that RFDs are especially useful in helping investors evaluate the underlying risks and future prospects of firms with greater information uncertainty and higher likelihood of default. Consistent with the Duffie and Lando’s (2001) model, we also document that the slope and concavity of the CDS spread-maturity relation become steeper after firms are mandated to provide RFDs. Overall, our findings suggest that the SEC’s mandate for a “risk factor” section in periodic reports enhances the content of corporate filings and facilitates investors in debt instruments evaluating credit quality of SEC registrants.

Do CDS spreads move with commonality in liquidity?

We show that commonality in liquidity is priced in both the cross-section and time-series of credit default swap (CDS) premia. Protection buyers earn a statistically significant and economically important discount for bearing the risk of individual CDS illiquidity co-moving with CDS market illiquidity. The pricing of commonality in CDS liquidity is different for calm and crisis periods as we find liquidity risk to be a priced factor in CDS spreads only during the recent financial crisis. Additionally, we find evidence that liquidity seems to be more important for the pricing of CDS than fundamentals from structural models of default risk.

Fiscal austerity, growth prospects, and sovereign CDS spreads: The Eurozone and beyond

This paper applies both conventional panel data models and a dynamic simultaneous equations model to analyze the impact of fiscal austerity and growth prospects along with other macro fundamentals on the pricing of sovereign credit default swaps (CDS) for a panel of 36 countries including the Eurozone. We find that austerity practice generally leads to an expectation of improved fiscal situations, which tends to help the CDS market grow more confidence in indebted sovereigns׳ ability to service their debt. The public debt to GDP ratio and projected future output growth also play an important role in determining the prices of sovereign debt insurance. Our analyses further show that the behavior of CDS spreads is considerably affected by common time trends over the sample period.

Sovereign risk and the pricing of corporate credit default swaps

Based on an empirical analysis of European corporations, we investigate the impact of sovereign risk on the pricing of corporate credit risk. In our paper, we show that sovereign credit default swaps (CDS) are positively correlated with corresponding corporate CDS spreads and are a significant factor for corporate CDS pricing models. We also find that this impact in-creases throughout the sovereign debt crisis in 2010-2011 and is more distinctive for Euro-zone countries that were more exposed to the sovereign debt crisis than others. We further observe that this effect is particularly pronounced for corporations with a high dependency on their domestic market.

Sovereign Risk and the Pricing of Corporate Credit Default Swaps

Based on an empirical analysis of European corporations, we investigate the impact of sovereign risk on the pricing of corporate credit risk. In our paper, we show that sovereign credit default swaps (CDS) are positively correlated with corresponding corporate CDS spreads and are a significant factor for corporate CDS pricing models. We also find that this impact increases throughout the sovereign debt crisis in 2010-2011 and is more distinctive for Eurozone countries that were more exposed to the sovereign debt crisis than others. We further observe that this effect is particularly pronounced for corporations with a high dependency on their domestic market.

Credit Risk and LGD Modelling

Abstract This paper deals with the methods for estimating credit risk parameters from market prices, e.g. Probability of Default (PD) and Loss Given Default (LGD). Precise evaluation of these parameters is important not only for bank to calculate their regulatory capital but also for investors to price risky bonds and credit derivatives. In this paper, we introduced reduced-form analytical methods for the calculation of LGD to pricing Credit Default Swaps. Reduced-form credit risk models were introduced as a reaction to structural approach, especially trying to decrease informational difficulty when modelling credit risk. In the reduced-form approach, the market value of defaulted bonds is the same as in the fraction recovered from the exposure at default. We use the face value convention, which Hull & White (2000) presented in their model which extended recovery of face value convention for coupon bonds.

The Debt Market Relevance of Disclosure Tone: Evidence from the Pricing of Credit Default Swaps

This paper examines whether corporate disclosure tone conveys credit risk-relevant information to the credit default swaps (CDS) market. Using a large sample of the Securities and Exchange Commission (SEC) 10-K and 10-Q filings, I find that the change in CDS spreads over the three-day window surrounding the SEC filing date is positively associated with the pessimism of the language used in the 10-K or 10-Q filing. Consistent with nonlinear payoff functions for creditors, this association is more pronounced for reference entities with speculative credit ratings. These findings indicate that the tone of periodic SEC filings is useful for CDS investors to evaluate the reference entity’s credit risk. In addition, I find stronger reaction of CDS spreads to disclosure tone when the CDS contract has shorter maturity, equity short sellers are more active, or the reference entity has lower visibility (i.e., smaller size or lower analyst coverage). Overall, these results support the view that disclosure tone has information content for investors in the CDS market in particular and the debt market in general.

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.

CDS and Equity Market Reactions to Stock Issuances in the U.S. Financial Industry: Evidence from the 2002-13 Period

We study market reactions to seasoned equity issuances that were announced by financial companies between 2002 and 2013. To assess the risk and valuation implications of these seasoned equity issuances, we conduct an event analysis using daily credit default swap (CDS) and stock market pricing data. The major findings of the paper are that CDS prices respond quickly to new, default-relevant information. Over the full sample period, cumulative abnormal CDS spreads drop in response to equity issuance announcements. The reactions are significantly stronger during the financial crisis. At that time, the federal government injected equity into financial institutions to ensure their viability. The market reacted to the equity issue announcements by assessing significantly lower costs for default protection via credit default swaps. The evidence indicates that single-name CDS based on financial firms’ default probabilities are potentially useful for private investors and regulators.

Investigating the Performance of Non-Gaussian Stochastic Intensity Models in the Calibration of Credit Default Swap Spreads

Most important financial models assume randomness is explained through a normal random variable because, in general, use of alternative models is obstructed by the difficulty of calibrating and simulating them. Here we empirically study credit default swap pricing models under a reduced-form framework assuming different dynamics for the default intensity process. We explore pricing performance and parameter stability during the highly volatile period from June 30, 2008 to December 31, 2010 for different classes of processes driven by Brownian motion, three non-Gaussian Levy processes, and a Sato process. The models are analyzed from both a static and dynamic perspective.

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.

Modeling and monitoring risk acceptability in markets: The case of the credit default swap market

Minimal discounted distorted expectations across a range of stress levels are employed to model risk acceptability in markets. Interactions between discounting and stress levels used in measure changes are accommodated by lowering discount rates for the higher stress levels. Acceptability parameters represent a maximal and minimal discount rate, a maximal stress level and the speed of rate reduction in response to stress. An explicit model relating credit default swap (CDS) prices to default probabilities is formulated with a view to making the default risk market acceptable. Data on CDS prices and default probabilities for the six major US banks obtained from the Risk Management Institute of the National University of Singapore is employed to estimate parameters defining acceptability and the movements in market implied recovery rates. We observe that the financial crisis saw an increase in the maximal discount rate and its spread over the minimal rate along with an increase in the maximal stress level being demanded for acceptability and a stable pattern for the speed of rate adjustment through the period. The maximal rate, rate spread and stress levels have come down but with periods in the interim where they have peaked as they did in the crisis. Recovery rates have oscillated and they did fall substantially but have recovered towards 40 percent near the end of the period.