Single-name Credit Default Swap Research Articles

Specification Analysis of Structural Credit Risk Models*

In this paper we conduct a specification analysis of structural credit risk models, using term structure of credit default swap (CDS) spreads and equity volatility from high-frequency return data. Our study provides consistent econometric estimation of the pricing model parameters and specification tests based on the joint behavior of time-series asset dynamics and cross-sectional pricing errors. Our empirical tests reject strongly the standard Merton (1974) model, the Black and Cox (1976) barrier model, and the Longstaff and Schwartz (1995) model with stochastic interest rates. The double exponential jump-diffusion barrier model (Huang and Huang, 2003) improves significantly over the three models. The best one among the five models considered is the stationary leverage model of Collin-Dufresne and Goldstein (2001), which we cannot reject in more than half of our sample firms. However, our empirical results document the inability of the existing structural models to capture the dynamic behavior of CDS spreads and equity volatility, especially for investment grade names. This points to a potential role of time-varying asset volatility, a feature that is missing in the standard structural models.

Market-Making Costs and Liquidity: Evidence from CDS Markets

In over-the-counter markets, dealers facilitate trading by becoming market makers. The costs dealers face, including the cost of holding inventory on balance sheet, and the ease, or difficulty, of reducing their positions, determine the degree of liquidity they provide. We provide a stylized model to examine the implications of these costs on dealer behavior and market liquidity. We use the model to guide an empirical study of the single-name credit default swap (CDS) market between 2010-2016. We find that transaction prices between dealers and clients have progressively become more dependent on the inventories of individual dealers rather than on the aggregate inventory across all dealers. We also find that the volume between clients and dealers decreases across all clients, with larger declines for clients that are depository institutions. At the same time, the volume of interdealer trades decreases, dealer inventories decline, and dealers with large inventories are more likely to trade with clients. Our results are consistent with the view that regulatory reforms implemented following the 2007-09 financial crisis increased the cost of holding inventory for dealers, and the cost of interdealer trading.

Hierarchical PCA and Applications to Portfolio Management

It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations. The model can also be used in markets in which the sectors have asynchronous price information, such as single-name credit default swaps, generalizing the works of Cont and Kan (2011) and Ivanov (2016).

Hierarchical PCA and Applications to Portfolio Management

It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations. The model can also be used in markets in which the sectors have asynchronous price information, such as single-name credit default swaps, generalizing the works of Cont and Kan (2011) and Ivanov (2016).

Market-Making Costs and Liquidity: Evidence from CDS Markets

In over-the-counter markets, dealers facilitate trading by becoming market makers. The costs dealers face, including the cost of holding inventory on balance sheet, and the ease, or difficulty, of reducing their positions, determine the degree of liquidity they provide. We provide a stylized model to examine the implications of these costs on dealer behavior and market liquidity. We use the model to guide an empirical study of the single-name credit default swap (CDS) market between 2010-2016. We find that transaction prices between dealers and clients have progressively become more dependent on the inventories of individual dealers rather than on the aggregate inventory across all dealers. We also find that the volume between clients and dealers decreases across all clients, with larger declines for clients that are depository institutions. At the same time, the volume of interdealer trades decreases, dealer inventories decline, and dealers with large inventories are more likely to trade with clients. Our results are consistent with the view that regulatory reforms implemented following the 2007-09 financial crisis increased the cost of holding inventory for dealers, and the cost of interdealer trading.

Credit market choice

Which markets do institutions use to change exposure to credit risk? Using a unique data set of transactions in corporate bonds and credit default swaps (CDS) by large financial institutions, we show that simultaneous transactions in both markets are rare, with an average institution having an 11 percent probability of transacting in both the CDS and bond markets in the same entity in an average week. When institutions do transact in both markets simultaneously, they increase their speculative positions in CDS by 13 cents per dollar of bond transactions, and their hedging positions by 13 cents per dollar of bond transactions. We find evidence that, during the post-crisis rule implementation period, the incentive to use paired transactions is reduced but so is the incentive to take naked positions in the CDS market. When single name contracts become eligible for central clearing, globally systemically important institutions become more likely to use single name CDS contracts. Finally, we show that, in the aggregate, U.S. globally systemically important institutions reduce their exposure to corporate credit risk in the rule implementation period, primarily through reducing the amount of credit protection sold in the index CDS market.

Cross-Market Liquidity and Dealer Profitability: Evidence from the Bond and CDS Markets

We study how the credit desk profitability of U.S. dealers that trade corporate bonds and single-name credit default swaps (CDS) affects the level and correlation of liquidity in these two markets. Supervisory datasets allow us to identify the dealers involved in each transaction and to observe their daily profit and loss (P&L). We find that profitability is important for bond liquidity and for liquidity correlation. Through the lens of a stylized model, we highlight that the impact of P&L on liquidity correlation depends on the interaction between profitability and inventory pressure driven by liquidity demand correlation. The interaction is richer when market stress is low, which has implications for measuring the impact of P&L on liquidity correlation, especially for complex intermediaries. For these institutions, inventory pressure arguably also reflects variables that are difficult to measure, like risk offsetting across business lines, but that are crucial to understanding the dynamics of liquidity comovement.

The Impact of Central Clearing on the Market for Single-Name Credit Default Swaps

In this article, we revisit the impact of the voluntary central clearing scheme on the CDS market. In order to address the endogeneity problem, we use a robust methodology that relies on dynamic propensity-score matching combined with generalized difference-in-differences. Our empirical findings show that central clearing results in a small increase in CDS spreads (ranging from 14 to 19 bps), while there is no evidence of an associated improvement in CDS market liquidity and trading activity or of a deterioration in the default risk of the underlying bond. These results suggest that the increase in CDS spreads can be mainly attributed to a reduction in CDS counterparty risk.

Political uncertainty and a firm's credit risk: Evidence from the international CDS market

Using a large sample of firms with single-name credit default swap (CDS) contracts in 30 countries, we document the evidence that political uncertainty, proxied by national election dummy, is positively related to firm-level credit risk. Specifically, this positive relation is more pronounced for the firms that have no political connection or poor international diversification, and in the countries with higher political uncertainty and lower investor protections. Further, by using a difference-in-differences approach, we find evidence to support idiosyncratic volatility and debt rollover channels through which political uncertainty affects the credit risk of individual firm.

An Examination of the Impact of the EU Ban on Naked Purchases of Sovereign Credit Default Swaps

We examine the impact of the November 2012 EU ban on the naked purchasing of EUsovereign credit default swaps (CDS). Using a change point model (CPM), we find thatthe ban directly reduced trading volumes for single-name CDS on EU sovereign linkedcredit. We show that the ban reduced price correlation between CDS and Eurozonesovereign bonds and we find that the tendency for CDS spread changes to ‘Grangercause’ bond spread changes dropped after the ban, with bond prices then leadingCDS prices in most core EU countries. Price discovery now occurs in the bond market.Overall, we see that the EU ban on the naked short selling of EU sovereign CDShas weakened the relationship between CDS and bond prices, making CDS hedgingless effective. We suggest that a non-functioning CDS market can lead to an increasein sovereign funding levels

Political Uncertainty and Credit Derivatives

Using a large sample of firms with single-name credit default swap (CDS) contracts in 30 countries, we document the evidence that political uncertainty, proxied by national election dummy, is positively related to firm-level credit risk. Specifically, this positive relation is more pronounced for the firms that have no political connection or poor international diversification, and in the countries with higher political uncertainty and lower investor protections. Further, by using a difference-in-differences approach, we find evidence to support idiosyncratic volatility and debt rollover channels through which political uncertainty affects the credit risk of individual firm.

The Value of Trading Relationships and Networks in the CDS Market

We investigate execution quality issues in the OTC single-name credit default swap (CDS) market using confidential transactions-level trade repository data. Specifically, we analyze the impact of counterparties’ matching and negotiation abilities on the terms of trade of CDS contracts, under incomplete information about market liquidity and quotes. We show that execution cost of a CDS transaction, measured as the deviation of the traded CDS spread from the market consensus spread, is explained, in part, by the counterparties’ trading activity level, trading networks, and trading relationships. Further, we test the importance of these determinants of execution cost under stressed market conditions, such as a crisis regime, low trading volume and high market volatility.

Why Do Investors Buy Sovereign Default Insurance?

We provide a comprehensive analysis of the determinants of trading in the sovereign credit default swaps (CDS) market, using weekly data for single-name sovereign CDS from October 2008 to September 2015. We describe the anatomy of the sovereign CDS market, derive a law of motion for gross positions and their components, and identify the key factors that drive the cross-sectional and time-series properties of trading volume and net notional amounts outstanding. While a single principal component accounts for 54 percent of the variation in sovereign CDS spreads, the largest common factor explains only 7 percent of the variation in sovereign CDS net notional amounts outstanding. Moreover, unlike for CDS spreads, common global factors explain very little of the variation in sovereign CDS trading and net notional amounts outstanding, suggesting that it is driven primarily by idiosyncratic country risk. We analyze several local and regional channels that may explain the trading in sovereign CDS: (a) country-specific credit risk shocks, including changes in a country's credit rating and related outlook changes, (b) the announcement and issuance of domestic and international debt, (c) macroeconomic sentiment derived from conventional and unconventional monetary policy, macro-economic news and shocks, and (d) regulatory channels, such as changes in bank capital adequacy requirements. All our findings suggest that sovereign CDS are more likely used for hedging than for speculative purposes.

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.

Pricing credit derivatives under a correlated regime-switching hazard processes model

In this paper, we study the valuation of a single-name credit default swap and a $k$th-to-default basket swap under a correlated regime-switching hazard processes model. We assume that the defaults of all the names are driven by a Markov chain describing the macro-economic conditions and some shock events modelled by a multivariate regime-switching shot noise process. Based on some expressions for the joint Laplace transform of the regime-switching shot noise processes, we give explicit formulas for the spread of a CDS contract and the $k$th-to-default basket swap.

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.

Related Securities and Equity Market Quality: The Case of CDS

AbstractWe document that equity markets become less liquid and equity prices become less efficient when markets for single-name credit default swap (CDS) contracts emerge. This finding is robust across a variety of market quality measures. We analyze the potential mechanisms driving this result and find evidence consistent with negative trader-driven information spillovers that result from the introduction of CDS. These spillovers greatly outweigh the potentially positive effects associated with completing markets (e.g., CDS markets increase hedging opportunities) when firms and their equity markets are in “bad” states. In “good” states, we find some evidence that CDS markets can be beneficial.

A Reduced-Form Model for Correlated Defaults with Regime-Switching Shot Noise Intensities

In this paper, we consider a two-dimensional reduced form contagion model with regime-switching interacting default intensities. The model assumes that the intensities of the default times are driven by macro-economy described by a homogenous Markov chain and that the default of one firm may trigger a positive jump, associated with the state of Markov chain, in the default intensity of the other firm. The intensities before the default of the other firm are modeled by a two-dimensional regime-switching shot noise process with common shocks. By using the idea of “change of measure” and some closed-form formulas for the joint conditional Laplace transforms of the regime-switching shot noise processes and the integrated regime-switching shot noise processes, we derive the two-dimensional conditional and unconditional joint distributions of the default times. Based on these results, we can express the single-name credit default swap (CDS) spread, the first and second-to-default CDS spreads on two underlyings in terms of fundamental matrix solutions of linear, matrix-valued, ordinary differential equations.

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.