Credit Default Swap Prices Research Articles

The Causal Linkages between Sovereign CDS Prices for the BRICS and Major European Economies

Abstract The article examines causal relationships between sovereign credit default swaps (CDS) prices for the BRICS and most important EU economies (Germany, France, the UK, Italy, Spain) during the European debt crisis. The cross-correlation function (CCF) approach that distinguishes between causality-in-mean and causality-in-variance and the Breitung– Candelon causality test in the frequency domain are used in the research. Both tests reveal limited dependence of the BRICS CDS (especially, in the case of Brazil, China and South Africa) on the EU CDS prices. Thus, the paper underscores the signs of decoupling in the sovereign CDS market and also supports the view that the European debt crisis has so far had a limited non-EU impact in this market.

Sovereign risk and its changing effects on bond duration during financial crisis

We examined the effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996 to 2011. We compared the sovereign risk-adjusted duration with the Macaulay duration for both investment- and speculative-grade US dollar-denominated sovereign bonds. We found that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all ratings, and the ‘shortening’ effect is stronger for lower rated bonds, which generally intensified during the recent financial crisis. Results are robust when credit default swap (CDS) prices are used as a proxy for changes in sovereign risk. This study provides evidence for advocating the importance of adjusting the bond duration for sovereign risk. More important, this study provides a practical methodology for estimating a sovereign risk-adjusted duration measure for managing international bond portfolios.

Do Private Signals of a Bank's Creditworthiness Predict the Bank's CDS Price? Evidence from the Eurosystem's Overnight Loan Rates

We investigate the between the daily average interbank overnight borrowing rate (AOR) and the credit default swap price (CDS) of 60 banks using the Eurosystem's proprietary data from mid-2008 to mid-2013. We find that the AOR which is observable only by the competent Eurosystem authorities leads the CDS at least by one day. The lead was concentrated on days of market stress for banks which mainly borrow from relationship lender banks. Such borrower banks are typically smaller, have weak ratings, and likely reside in crisis countries.

The pricing of credit default swaps under a generalized mixed fractional Brownian motion

In this paper, we consider the pricing of the CDS (credit default swap) under a GMFBM (generalized mixed fractional Brownian motion) model. As the name suggests, the GMFBM model is indeed a generalization of all the FBM (fractional Brownian motion) models used in the literature, and is proved to be able to effectively capture the long-range dependence of the stock returns. To develop the pricing mechanics of the CDS, we firstly derive a sufficient condition for the market modeled under the GMFBM to be arbitrage free. Then under the risk-neutral assumption, the CDS is fairly priced by investigating the two legs of the cash flow involved. The price we obtained involves elementary functions only, and can be easily implemented for practical purpose. Finally, based on numerical experiments, we analyze quantitatively the impacts of different parameters on the prices of the CDS. Interestingly, in comparison with all the other FBM models documented in the literature, the results produced from the GMFBM model are in a better agreement with those calculated from the classical Black–Scholes model.

Pricing credit default swaps with bilateral counterparty risk in a reduced form model with Markov regime switching

This paper provides an intensity-based model with Markov regime switching. We assume that the default intensities depend on the economic state described by a Markov chain and that default dependence comes from common shock. We derive some closed-form expressions for the joint distribution of the default times and a pricing formula of credit default swap (CDS) with bilateral counterparty risk. We use two different approaches to obtain the closed pricing formula. We perform some numerical experiments to examine how the default intensities and the regime switching affect the CDS spread.

Pricing Credit Default Swap under Fractional Vasicek Interest Rate Model

This paper discusses the pricing problem of credit default swap in the fractional Brownian motion environment. As credit default swap is exposed to both the interest rate risk and the default risk, we assume that the default intensity of a firm depends on the stochastic interest rate and the default states of counterparty firms. The interest rate risk is reflected by the fractional Vasicek interest rate model. We model the firm’s default intensity under the looping default model and derive the pricing formulas of risky bonds and credit default swap.

The pricing of single name credit default swap based on jump-diffusion process and volatility with Markov regime shift

Credit derivatives are efficient tools to manage credit risk. The single name credit default swap (CDS) is one of the most popular credit derivatives. The pricing is the important issue for credit derivatives. By introducing the jump-diffusion process and volatility with Markov regime shift, the paper makes some research on the pricing problem of single name CDS, which the price of CDS is affected by both unpredictable idiosyncratic risk and systematic risk caused by the macroeconomic change. Monte Carlo simulations find that the price of CDS increases as the intensity and the amplitude of the jump-diffusion process increase. Furthermore, the CDS price depends on the initial state and transition intensity of the volatility of the firm value, which the former can reflect the influence of the macroeconomic situation.

Market Signals and the Cost of Credit Risk Protection: An Analysis of CDS Settlement Auctions

We study the link between the probability of default implied by Credit Default Swaps (CDS) spreads and the final prices of the defaulted bonds as established at the CDS settlement auctions. We observe that the post-default recovery rates at the observed spreads imply markets were often “surprised” by the credit event. We find that the prices of the bonds that are deliverable at the auctions imply probabilities of default that are systematically different than the default probabilities estimated prior to the event of default using standard methodologies. We discuss the implications for CDS pricing models. We analyze the discrepancy between the actual and theoretical CDS spreads and we find it is significantly associated both to the CDS market microstructure at the time of the settlement auction and to the general macroeconomic background. We discuss the potential for strategic bidding behavior at the CDS settlement auctions.

Market Signals and the Cost of Credit Risk Protection: An Analysis of CDS Settlement Auctions

We study the link between the probability of default implied by Credit Default Swaps (CDS) spreads and the final prices of the defaulted bonds as established at the CDS settlement auctions. We observe that the post-default recovery rates at the observed spreads imply markets were often “surprised” by the credit event. We find that the prices of the bonds that are deliverable at the auctions imply probabilities of default that are systematically different than the default probabilities estimated prior to the event of default using standard methodologies. We discuss the implications for CDS pricing models. We analyze the discrepancy between the actual and theoretical CDS spreads and we find it is significantly associated both to the CDS market microstructure at the time of the settlement auction and to the general macroeconomic background. We discuss the potential for strategic bidding behavior at the CDS settlement auctions.

The impact of different correlation approaches on valuing credit default swaps with counterparty risk

This paper has two main contributions. We first build a general framework for valuing credit default swaps (CDS) with counterparty risk. We extend the work of Hull and White, and Hamp, Kettunen and Meissner, and build two quadruple trees. One tree represents the CDS spread payments, and one tree represents the CDS payoffs in the case of default. The trees are then combined using swap evaluation techniques to derive a closed-form solution for the CDS spread including counterparty risk. This is our first contribution. Our second contribution is testing the impact of five different reference asset–counterparty dependence concepts on the CDS price. We find that different dependence approaches lead to significanly different CDS spreads. The basic version of the model can be calibrated to market CDS spreads. A Visual Basic source code of the model can be provided upon request.

Regulation, Credit Risk Transfer with CDS, and Bank Lending

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank . CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price . Regulation is found to induce the risk-neutral bank to behav e in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases . CDS trading is found to interact with the former ef fect when regulation accepts CDS as an instrument to mitigate credit risk . Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased . Howev er, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased . This promotes the intention of the Basel II (and III) r egulations to “strengthen the soundness and stability of banks” . * Paper presented at the 2012 conferences of the European Financial Management Association (EFMA) in Barcelona and the Verein fur Socialpolitik in Gottingen, at the 2011 conference of the German Economic Association of Business Administration (GEABA) in Zurich, at the Financial Risks International Forum 2012 in Paris, at the 2011 workshop of the Research Task Force of the Basel Committee on Banking Supervision in Istanbul, and at the Bundesbank Research Seminar in Frankfurt . We w ould like to thank conference, workshop and seminar participants and in particular Ulrich Krueger, Peter Raupach, Thomas Gehrig, Bent Vale and Nikolaos Papanikolaou for valuable comments and suggestions . The views expr essed in this paper represent the authors’ personal opinions and do not neces

The valuation of credit default swaps including investor–counterparty–reference entity default correlation

We extend the work of Hull and White and Kettunen and Meissner and build a credit default swap (CDS) pricing model that includes default intensities and default correlation of all three involved entities, i.e., the investor (the CDS buyer), the counter-party (the CDS seller) and the underlying reference entity. We build the model in a discrete time frame, so that the user can match the timing of CDS spread payments exactly and alter cash flows if desired. We combine two octuplet trees and use swap evaluation techniques to derive a closed-form solution for the CDS spread including default correlation of all three entities. We find that the default intensity of the investor has a strong impact on the CDS spread, whereas the default correlation of the investor with other CDS entities has a minor impact. The Matlab source code of the model is provided upon request.

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.

Determinants of credit default swaps spreads in European and Asian markets

This article re-examines the determinants of credit default swaps (CDS) spreads in the United States, Europe and Asia-Pacific markets with new data set using linear regressions. These determinants are categorized into two groups: firm-level and macroeconomic variables. We also include two non-traditional moment risk variables in the analysis as we suspect that these measures may capture the effects of possible extreme downside risk, or extreme negative scenarios, in the underlying credit valuation process. Our findings from the United States and abroad confirm the existing evidence on the significant relationship between theoretical determinants of default risk and actual market pricing of CDS. In addition, we provide additional evidence on the importance of the interaction between macroeconomic and firm-specific variables, which is common throughout the world.

Can CDS indexes signal future turmoils in the stock market? A Markov switching perspective

Single-name Credit Default Swaps (CDS) are considered the main providers of direct information related with a reference entity’s creditworthiness and, for this reason, they have often been the core of news on the current financial crisis. The academic research has focused mainly on the capacity of CDS in anticipating agencies’ official rating changes and—in this respect—on their superior signalling power, compared to bond and stock markets. The aim of this work is, instead, to investigate the ability of fluctuations in CDS indexes in anticipating the occurrence of stock market crises. Our goal is to show that CDS indexes may provide investors and institutions with early warning signals of financial distresses in the stock market. We make use of a Markov switching model with states characterized by increasing levels of volatility and compare the times in which the first switch in a high volatility state occurs, respectively, in CDS and stock market index quotes. The data set consists of daily closing quotes for 5 years CDS and stock market index prices, covering the time period from 2004 to 2010. In order to capture possible geographic differences in CDS index capacity of foreseeing stock market distresses, data referring to two different regions, Europe and United States, are analyzed.

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 18bp reduction on its five-year CDS spread as a result of lower opacity following SOX, amounting to total annual savings of $ 844million 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 credit default swaps with bilateral value adjustments

The paper studies the problem of computing adjustments for bilateral counterparty risk for a standard CDS in a three-factor first-passage time default risk model. Extending the existing literature that gives analytical expression for the transition probability density function (or Green’s function) for two-dimensional Brownian motions absorbed at the boundaries in the positive quadrant, this paper gives a semi-analytical expression for Green’s function for three-dimensional Brownian motions absorbed at first exit time from the positive octant. This is done by separating the problem into a radial and an angular part, of which the latter is universal and depends only on the correlation matrix. These mathematical results are then used to provide semi-analytical expressions for bilateral CVA/DVA of a credit default swap. An example of market data is analysed in detail and it is shown that these value adjustments can be surprisingly large.

Evaluation of conducting capital structure arbitrage using the multi-period extended Geske–Johnson model

This study utilizes a multi-period structural model developed by Chen and Yeh (Pricing credit default swaps with the extended Geske–Johnson Model. Working paper, 2006), which extends the Geske and Johnson (J Financ Quant Anal 19:231–232, 1984) compound option model to evaluate the performance of capital structure arbitrage. In the paper, first of all, we predict the default probability for each firm using the multi-period Geske–Johnson model that assumes endogenous default barriers. Second, based on the arbitrage performance of 369 North American obligators from 2004 to 2008, we find that the extended Geske–Johnson model is more suitable than the CreditGrades model for exploiting the mispricing between equity prices and credit default swap spreads. Finally, the Geske–Johnson model also performs well in extreme market condition, such as the financial crisis around 2008.

Are All Credit Default Swap Databases Equal?

AbstractWe compare the five major sources of corporate Credit Default Swap prices: GFI, Fenics, Reuters, CMA, and Markit, using the most liquid single name 5‐year CDS in the iTraxx and CDX indexes from 2004 to 2010. Deviations from the common trend among prices in the different databases are not random but are explained by idiosyncratic factors, financing costs, global risk, and other trading factors. The CMA quotes lead the price discovery process. Moreover, we find that there is not a full agreement among databases in the results of the price discovery analysis between stock and CDS returns.

CREDIT DERIVATIVES PRICING WITH STOCHASTIC VOLATILITY MODELS

This paper proposes a model for pricing credit derivatives in a defaultable HJM framework. The model features hump-shaped, level dependent, and unspanned stochastic volatility, and accommodates a correlation structure between the stochastic volatility, the default-free interest rates, and the credit spreads. The model is finite-dimensional, and leads (a) to exponentially affine default-free and defaultable bond prices, and (b) to an approximation for pricing credit default swaps and swaptions in terms of defaultable bond prices with varying maturities. A numerical study demonstrates that the model captures stylized various features of credit default swaps and swaptions.