Reference Entity Research Articles

How did the Greek credit event impact the credit default swap market?

This paper studies how the Greek sovereign credit event in March 2012 impacted the credit default swap (CDS) market from market-wide and investor behaviour perspectives, using both network tools to a dataset of snapshots of the global bilateral CDS exposures and a panel analysis on CDS spreads. Regarding the CDS spreads, we find very little discernible direct impact of the Greek credit event on CDS spreads overall. This finding provides some further evidence that the Greek credit event was well anticipated by most market participants. However, we find several significant changes in the Greek CDS network structure following the credit event: the number of connections via exposures declined significantly, the directionality of the positions (net long vs net short) of the main groups of market participants reversed, while none of the non-banks returned to trade Greek CDSs until the last observation of dataset (October 2014). Regarding indirect effects to other CDS markets, we find evidence of temporary spill-over effects on CDS reference entities with credit risk associated with the risk of the Greek sovereign. In particular, the market and counterparty structures changed temporarily with all types of traders decreasing their exposures to the EU periphery sovereign reference entities and also changing their trading counterparties, while after some time, the structure of the market returned to a similar one observed before the credit event. Finally, we find some support for the bank-sovereign nexus, as there was a consistent retreat from the CDS exposures on banks in the EU periphery countries, contrary to banks residing in the other EU countries.

Liquidity basis between credit default swaps and corporate bonds markets

Liquidity risk has drawn much attention among academic researchers, institutional professionals and financial regulators in various financial markets. This paper empirically investigates the difference and relationship between the liquidities of CDS and corporate bond markets. The liquidity basis which is defined as the difference of liquidity between CDS and corporate bond are negative most of the time across different rating categories, implying more illiquid corporate bond market and the fact that CDS market moves quickly in reflecting credit quality changes. There exists significant Granger-causality from CDS liquidity to bond liquidity, and some bidirectional Granger-causality for some investment grade reference entities. The empirical tests are performed in the VAR system including the monetary policy variables and financial market variables. The relative bid-ask spread adopted by many researchers turns out to be less reliable as a measure of liquidity for CDS and corporate bond where the credit spread and liquidity risk are positively correlated.

Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

The Information in Credit Default Swap Volume

This article examines the informational content of credit default swap (CDS) net notional for future stock and CDS prices. Using the information on CDS contracts registered in DTCC, a clearinghouse, I construct CDS-to-debt ratios from net notional, that is, the sum of net positive positions of all market participants, and total outstanding debt issued by the reference entity. Unlike the ratio using the sum of all outstanding CDS contracts, this ratio directly indicates how much of debt is insured with CDS and therefore, is a natural measure of investors’ concern on a credit event of the reference entity. Empirically, I find crosssectional evidence that the current increase in CDS-to-debt ratios can predict a decrease in stock prices and an increase in CDS premia of the reference firms in the next week. Greater predictability for firms with investment grade credit ratings or low CDS-to-debt ratios suggests that investors pay more attention to firms in good credit conditions than those regarded as junk or already insured considerably with CDS.

Time-Varying Price Discovery Dynamics of Corporate Credit Default Swaps and Bonds

This paper empirically analyzes in a time-varying context if the U.S. corporate Credit Default Swaps (CDS) and bond markets of 81 reference entities reflect the same information on their prices between October 2004 and December 2010. The analysis shows that the theoretical no-arbitrage relation between CDS and bond spreads holds during economic stable times, but is violated as soon as markets are exposed to economic turmoil as in the financial crisis starting in August 2007. The difference between CDS and bond spreads, called the basis, is more volatile the lower the firms are rated. The price discovery is unaffected by the reference entities' credit rating and is strongly time-varying. Nevertheless the CDS spreads lead the price discovery process. Price discovery is significantly influenced uniquely by counterparty risk only when economic risks achieve abnormal levels as during the 2007/2008 financial crisis. Other risks as interbank liquidity risk, global risk and financing costs aren't considered by CDS traders when markets are facing abnormal risks. The more the markets are exposed to counterparty risk, defined as the risk that the CDS seller defaults, the less the price discovery takes place in the CDS market and therefore the more the bond spreads tend to reflect credit risk more efficiently than the CDS spreads. Thus market participants have the tendency to abscond from the CDS market as soon as counterparty risk is elevated. Because price discovery still takes place in the CDS market, economic risks are strongly underestimated by market participants.

CDS, Borrowing Costs, and Investment: Spillovers from Speculation and Financial Innovation

This paper highlights two new effects of credit default swap (CDS) markets in a general equilibrium setting. First, CDSs affect firms' ex ante decision to issue defaultable debt. Specifically, firms choose between two debt contracts to finance investment--a safe debt claim that is repaid in all states, and a risky debt claim that defaults in some states. The safe debt contract requires issuing fewer bonds and investing less to ensure repayment in bad states. Issuing risky bonds maximizes profits in good states at the expense of default in bad states. CDSs alter the cost of issuing risky debt, which affects the opportunity cost of issuing safe debt. When CDS buyers hedge (speculate on) credit risk, CDSs lower (raises) credit spreads and increase (decrease) the likelihood that firms choose to issue risky debt. Second, when firms' cash flows are correlated, CDSs impact the cost of capital–credit spreads–and investment for all firms, even those that are not CDS reference entities.

Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default

This paper highlights two new effects of credit default swap markets (CDS) in a general equilibrium setting. First, when firms' cash flows are correlated, CDSs impact the cost of capital {credit spreads {and investment for all firms, even those that are not CDS reference entities. Second, when firms internalize the credit spread changes, the incentive to issue safe rather than risky bonds is fundamentally altered. Issuing safe debt requires a transfer of profits from good states to bad states to ensure full repayment. Alternatively, issuing risky bonds maximizes profits in good states at the expense of default in bad states. Profits fall when credit spreads increase, which raises the opportunity cost of issuing risky debt compared to issuing safe debt. Symmetrically, lower credit spreads reduce the opportunity cost of issuing risky debt relative to safe debt. CDSs affect the credit spread at which firms issue risky debt, and ultimately the opportunity cost of issuing defaultable bonds

Credit risk signals in CDS market vs agency ratings

Purpose This research aims to model the relationship between the credit risk signals in the credit default swap (CDS) market and agency credit ratings, and determines the factors that help explain the variation in such signals. Design/methodology/approach A comprehensive analysis of the differences in the relative credit risk assessments of CDS-based risk signals and agency ratings is provided. It is shown that the divergence between credit risk signals in the CDS market and agency ratings is explained by factors which the rating agencies may consider differently than credit market participants. Findings The results suggest that agency credit ratings of relative riskiness of a reference entity do not always correspond with assessments by CDS spreads, as the price of risk is a function of additional macro and micro factors that can be explained using statistical analysis. Originality/value This research is unique in modeling the relationship between the credit risk assessments of the CDS market and the agency ratings, which to the best of the authors' knowledge has not been analyzed before in terms of their agreement and the level of discrepancy between them. This model can be used by investors in debt instruments that are not explicitly CDSs or which have illiquid CDS contracts, to replicate market-based, point-in-time credit risk signals. Based on both market-based and firm-specific factors in this model, the results can be used to augment through-the-cycle credit risk assessments, analyze issues surrounding the pricing of CDSs and examine the policies of credit rating agencies.

Dosimetry for animals and plants: contending with biota diversity.

Diversity of living organisms and their environmental radiation exposure conditions represents a special challenge for non-human dosimetry. In order to contend with such diversity, the International Commission on Radiological Protection (ICRP) has: (a) set up points of reference by providing dose conversion coefficients (DCCs) for reference entities known as 'Reference Animals and Plants' (RAPs); and (b) used dosimetric models that pragmatically assume simple body shapes with uniform composition and density, homogeneous internal contamination, a limited set of idealised external radiation sources, and truncation of the radioactive decay chains. This pragmatic methodology has been further developed and extended systematically. Significant methodological changes include: a new extended approach for assessing doses of external exposure for terrestrial animals, transition to the contemporary ICRP radionuclide database, assessment-specific consideration of the contribution of radioactive progeny to dose coefficients of parent nuclides, and the use of generalised allometric relationships in the estimation of biokinetic or metabolic parameters. The new methodological developments resulted in a revision of the DCCs for RAPs. Tables of the dose coefficients have now been complemented by a web-based software tool, which can be used to calculate a user-specific DCC for an organism of arbitrary mass and shape, located at user-defined height above the ground, and for an arbitrary radionuclide and its radioactive progeny.

Pricing CDS spreads with Credit Valuation Adjustment using a mixture copula

Credit derivatives pricing models before Basel III ignored losses in market value stemming from higher probability of counterparty default. We propose a general credit derivatives pricing model to evaluate a Credit Default Swap (CDS) with counterparty risk, including the Credit Valuation Adjustment (CVA) in order to optimize the economic capital allocation. We work from the model proposed by Luciano (2003, Working Paper, International Center of Economic Research) and the general pricing representation established by Sorensen and Bollier (Financial Analysts Journal 1994;50(3):23–33) to provide a model close to the market practice, easy to implement and fitting with Basel III framework. We approach the dependence between counterparty risk and that of the reference entity with a technical tool: the copula, in particular, the mixture one that combines common “extreme” copulas. We study the CDS's vulnerability in extreme dependence cases. By varying Spearman's rho, the mixture copula covers a broad spectrum of dependence and ensures closed form prices. We end up with an application on real market data.

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.”

Counterparty Risk in Bond Mutual Funds: Evidence from Credit Default Swaps Positions

We examine the credit default swaps (CDS) positions of bond mutual funds over 2004-2009. We find that CDS are more commonly used by funds with the greatest transaction-cost benefit and that CDS usage is associated with lower flow-motivated trading in the bond market. We also find that bond funds’ net-buying of CDS protection dropped significantly during the 2007-2009 financial crisis. Consistent with bond funds’ avoiding buy protection positions out of heightened concerns about the counterparty risk of swap dealers, we find that funds are more likely to close existing buy-protection CDS that have greater counterparty credit risk, as measured by positions in which the counterparty has a high default probability or a high default correlation with the reference entity. Furthermore, as a further contributor to a decrease in net-buy protection during the crisis, we find an increase in funds’ selling of CDS protection during the crisis, especially to banks in greater financial distress. Finally, we show that the portfolios of CDS-users displayed significantly higher systematic credit risk and lower returns during the crisis.

Analysis of the Contagion Effect to the Credit Derivative Valuation

This study explores a credit derivative pricing model with counterparty risk and the contagion effect. To compare with the standard credit derivative pricing model, we analyze the counterparty risk and the contagion effect to a kth-to-default Basket Credit Linked Note (BCLN) valuation by Monte Carlo simulation. Counterparty risk and the contagion effect show significant influence for kth-to-default BCLN valuation. Especially with high k, the BCLN pricing model with the counterparty risk and the contagion effect captures chain defaulting phenomenon successfully. It indicates the higher the kth-to-default BCLN or the lower the correlation degree within reference entities, the more significant the contagion effect becomes to the kth-to-default BCLN valuation. Parameters sensitivity analyses indicate that the coupon rates of the third-to-default BCLN are lower with the higher risk-free rate or the shorter maturity. The higher hazard rate or the lower recovery rate of reference entities results in the higher coupon rates of the third-to-default BCLN. Lastly, the hazard rate and the recovery rate of the counterparty are less sensitive to the BCLN pricing. The major contribution in this study is that the credit derivative pricing model with the contagion effect is developed to capture the default chain reaction, and the valuation performance is significant numerically.

Multi Currency Credit Default Swaps: Quanto Effects and FX Devaluation Jumps

Credit Default Swaps (CDS) on a reference entity may be traded in multiple currencies, in that protection upon default may be offered either in the domestic currency where the entity resides, or in a more liquid and global foreign currency. In this situation currency fluctuations clearly introduce a source of risk on CDS spreads. For emerging markets, but in some cases even in well developed markets, the risk of dramatic Foreign Exchange (FX) rate devaluation in conjunction with default events is relevant. We address this issue by proposing and implementing a model that considers the risk of foreign currency devaluation that is synchronous with default of the reference entity. Preliminary results indicate that perceived risks of devaluation can induce a significant basis across domestic and foreign CDS quotes. For the Republic of Italy, a USD CDS spread quote of 440 bps can translate into a EUR quote of 350 bps in the middle of the Euro-debt crisis in the first week of May 2012. More recently, from June 2013, the basis spreads between the EUR quotes and the USD quotes are in the range around 40 bps. We explain in detail the sources for such discrepancies. Our modeling approach is based on the reduced form framework for credit risk, where the default time is modeled in a Cox process setting with explicit diffusion dynamics for default intensity/hazard rate and exponential jump to default. For the FX part, we include an explicit default-driven jump in the FX dynamics. As our results show, such a mechanism provides a further and more effective way to model credit / FX dependency than the instantaneous correlation that can be imposed among the driving Brownian motions of default intensity and FX rates, as it is not possible to explain the observed basis spreads during the Euro-debt crisis by using the latter mechanism alone.

The information content of the open interest of credit default swaps

This article addresses the information content of the open interest of CDS markets. Using a panel database of 481 firms, I show that open interest innovations help to predict subsequent CDS rate changes and stock returns. The open interest dynamics appears to convey specific information on the reference entity and common information. On the one hand, there is evidence that positive open interest growth precedes the announcement of negative earnings surprises, and that high open interest growth prior to these events is linked to positive and significant CDS rate changes. This forecasting power relates with proxies of investors’ attention and market frictions. The predictive power on CDS rates is larger for illiquid contracts and for entities with low credit risk, whereas the predictive power over stock returns is larger for entities that display greater open interest outstanding. On the other hand, this article also shows that the aggregate open interest growth has predictive power on the subsequent returns of CDS and bond main indexes, and to a lesser extent on stock market returns.

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.

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.

European Corporate Credit Returns: A Risk Return Analysis

Integration of European Capital markets has coincided with the development and exponential growth of credit derivative markets. As credit derivatives have matured as an asset class, we can regard them as return generating assets and not simply as risk transfer vehicles. The Capital Asset Pricing Model (CAPM) suggests that the return of holding such assets should be commensurate with their risk. This paper examines the risk-return characteristics of European Credit Default Swaps (CDSs). We empirically test the higher moment CAPM using European CDS returns collected from 2007 to 2010 on a broad range of investment grade corporate reference entities. Our findings show that both systematic risk and higher moment risks are significant in explaining European CDS returns. These are significant findings in an area of finance where there is currently a paucity of research.

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

Using mutual funds quarterly holdings of credit default swap (CDS) contracts from pre- to post-financial crisis, we analyze the motives for and consequences of funds' CDS investment. Funds resort to CDS selling when facing unpredictable liquidity needs and when the CDS security is liquid relative to the underlying bond, and to CDS buying as part of a negative basis trade when the bond is illiquid. Funds CDS strategies tilt toward yield enhancement, and smaller funds follow leading funds in risk taking. The reference entities that attracted the highest selling interest from the large funds were disproportionately large financial institutions.