Single-name Credit Default Swap Research Articles

Single-Name Credit Default Swaps: How to Ensure Independent Credit Event Decisions?

Single-Name Credit Default Swaps: How to Ensure Independent Credit Event Decisions?

Enhanced Transparency on Single-Name Credit Default Swaps: A Comparison Between the US and the EU

Enhanced Transparency on Single-Name Credit Default Swaps: A Comparison Between the US and the EU

Single-Name Credit Default Swaps: Increased Disclosure to Mitigate Manufactured Credit Events?

Single-Name Credit Default Swaps: Increased Disclosure to Mitigate Manufactured Credit Events?

Will a reviewed European Markets in Financial Instruments Regulation (MiFIR) Make Single-Name Credit Default Swaps more Transparent?

Will a reviewed European Markets in Financial Instruments Regulation (MiFIR) Make Single-Name Credit Default Swaps more Transparent?

Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

We investigate how market participants price and manage counterparty credit risk 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. For contracts ineligible for central clearing, 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 low. For clearable contracts, we find that nondealers are more likely to clear during a crisis and less likely to clear when the reference entity is a large U.S. dealer or a sovereign. This paper was accepted by Kay Giesecke, finance. Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2023.4870 .

SPECIFICATION ANALYSIS OF STRUCTURAL CREDIT RISK MODEL WITH STOCHASTIC VOLATILITY

In this research, we conduct specification analysis of structural credit risk models with stochastic volatility using term structure of Credit Default Swap (CDS) spreads and equity volatility form high-frequency return data. We also test five representatives of structural credit risk models using samples of 93 single name CDS contracts from January 2010 -2022. The model we consider are; the standard Merton(1974) model, the Black & Cox (1976) model with flat barrier, the Longstaff and Schwartz(1995)model with stochastic interest rates, the Collin- Dufresne and Goldstein (2001) model with stationary leverage, and the double exponential jump diffusion model used in Huang & Huang(2003). 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) with flat barrier model, the Longstaff, Schwartz (1995) model with stochastic interest rates. The double exponential jump-diffusion barrier model used in (Huang and Huang, 2003) improves significantly over the five models. The best model is the stationary leverage model of Collin-Dufresne and Goldstein (2001), which we cannot reject at 0.5 level of significance in our sample firm. 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 high investment grade names derivatives. These points to a potential role of time-varying asset volatility, a feature that is missing in the standard structural models.

On the choice of central counterparties in the EU

We study competition between European Union’s Central CounterParties (CCPs) on the credit default swap (CDS) market. Using data on market shares, we show that CCPs have a monopoly for single-name CDSs and compete on indices along various dimensions. Using transactions data, we focus on the major dealers who alternatively clear their transactions on the two main CCPs. Estimating their choice of CCP reveals that fees, CCPs’ robustness and activity, dealers’ risk, and market volatility are significant. Dealers’ positions indicate that saving on collateral costs is secondary relative to the benefits of dual membership and quality.

On Wasserstein distances, barycenters, and the cross-section methodology for proxy credit curves

The credit default swap (CDS) market plays an important role for financial institutions. This is not only for their trading activities, but also as it provides a source of information to extract default probabilities to be used for (counterparty) credit risk purposes, as for instance in credit valuation adjustment calculations. Nonetheless, the number of entities for which liquid single-name CDSs are traded is of the order of a few thousands. This requires financial institutions to employ proxy methodologies to estimate the credit risk they face when trading with counterparties for which no (liquid) CDSs are available in the market. In this paper, we propose and compare different approaches to take into account counterparty-specific information in terms of rating, region, sector, etc. at cross-sectional level to strip risk-neutral default probabilities from CDSs. This is achieved by taking into account the intrinsic probabilistic information characterizing each CDS by means of suitably-defined Wasserstein distances and barycenters. The results suggest that default probabilities are likely to be overestimated if the construction of the proxy credit curves overlooks the probability structure underlying the CDS market, potentially resulting in a too conservative counterparty credit risk pricing framework.

Indifference pricing of credit default swaps in a multi-period model

Credit default swaps (CDS) are the most common type of credit derivatives used for hedging and speculative purposes in credit markets. We consider a representative risk-averse investor who has initial endowment in credit instrument and invests in traditional financial instruments. Using the utility indifference pricing approach, we construct a pricing framework for single-name CDS contracts with periodic payments in a multi-period model. Moreover, we analyze CDS buyers with different trading motives, and examine the effect of risk aversion on the indifference upfront prices and credit spreads of CDS for investors with hedging or speculative motives. In particular, our results show that speculation in the CDS market provides a potential explanation for the formation of the negative CDS-bond bases during and after the global financial crisis.

Internet Searches, Household Sentiment, and Credit Spreads

We use Google internet search volumes to measure households’ pessimism about overall market-wide credit health in the economy and show that this “household default sentiment” is positively correlated with the credit default swap (CDS) spread level in the market. However, while household default sentiment might drive the cost of credit to some degree, either directly or indirectly through its effect on the stock market, we find the stock market’s opinion about the credit risk in the economy (default probabilities backed out from structural models) to be much more important in explaining credit spreads. The rather weak link between household sentiment and CDS spreads, meanwhile, is consistent with the almost complete absence of retail investors (households) in the institutional investor-dominated credit derivatives market. The results are essentially the same, whether we look at market-wide CDS indexes or single-name CDS contracts, and whether we exclude the financial crisis or not.

A three-factor hazard rate model for single-name credit default swap pricing

We propose a reduced-form model that integrates the modeling of interest rates, equity and default hazard rates. In this model the evolution of the risk-neutral hazard rate is driven by three risk factors: the reference firm’s equity price (in logarithmic form), the risk-free short rate and a latent risk premium factor that is orthogonal to the first two. The equity price and the short rate are considered to be the two primary risk factors, while the risk premium factor is introduced to capture the remaining risks for the hazard rate (such as the liquidity risk). The equity price follows a diffusion process with the possibility of a jump to default, the short rate is governed by a Vasicek model, and the dynamics of the risk premium factor are modeled as a Cox– Ingersoll–Ross process. Under the three-factor model, we derive computable pricing formulas for defaultable zero-coupon bonds, European call options and standard running credit default swaps (CDSs).We then discuss the calibration of the model using CDS and equity option data. Our numerical results reveal that the model is able to interpret a diverse set of CDS spread term structures.

Cash CVA -- Credit Valuation Adjustment in the Cash Form

Credit default swaps (CDS) are unfunded, or the synthetic form of credit exposure, while bonds are fully funded, thus the cash form. Borrowing this industry jargon, credit valuation adjustment (CVA) would be seen synthetic, because it is defined as the present value of buying a default protection on counterparty exposure through CDS. This article presents the cash form of counterparty risk, Cash CVA. It links directly to counterparties’ senior unsecured bond curves, thus no longer requiring recovery rate and CDS curve inputs. Replacing CVA with cash CVA is necessitated, because single name CDS is no longer liquid following massive dealer-bank exit from CDS trading business post the Financial Crisis of 2007-2008, while bond liquidity has significantly improved due to advances in corporate bond electronic trading.

Evaluation of market risk associated with hedging a credit derivative portfolio

Hedging a credit portfolio using single-name credit default swap (CDS) is affected by low liquidity and high spread volatility, which induces continuous changes in a portfolio mark-to-market. As an alternative, we consider hedging a derivative portfolio by taking a contrary position in a credit index, evaluating the empirical market risk that remains after such hedge. We perform three different hedging exercises: for single-names, for sectorial portfolios and for regional portfolios. We implement least squares hedging as a benchmark, and compare its efficiency with a hedge ratio estimated under the RiskMetrics exponentially moving average (EWMA) specification for time varying second order moments, as well as with the hedge ratio obtained from a bivariate GARCH model for the portfolio and the credit index used as a hedge. Over the 2007–2012 period, we find a high hedging efficiency for regional portfolios (Europe, North America and Japan), as well as for a global portfolio, which is back at pre-crisis levels. The EWMA hedge is slightly more efficient than the least-squares hedge, while the GARCH hedge does not improve hedging efficiency. Hedging efficiency is not as high for sectorial credit portfolios from Europe and North America, due to their more important idiosyncratic component. Taking into account the quality of the credit counterpart improves the effectiveness of the hedge, although it requires using less liquid credit indices, with higher transaction costs. This hedging strategy becomes much more complex if firms in the portfolio have a large idiosyncratic component. The efficiency of the hedge is higher when liquidity risk and systematic risk are high, or when the term structure is flat. We also provide evidence suggesting that credit indices can also offer a moderately efficient hedge for corporate bond portfolios, which we have examined with a reduced sample of firms over 2006–2018.

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.

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.

Pandemic Exposure, Credit Market Reactions, and Corporate Default Risk

This paper provides an innovative theoretical model and empirical evidence for how firm-level pandemic exposure, as an informational shock, increases a firm's credit spread and default risk. We find a positive relationship between pandemic exposure and single-name CDS spreads, and this empirical relationship remains under robustness checks and after controlling for endogeneity. Furthermore, we find that this effect of pandemic risk is more pronounced for firms with higher leverage. COVID-19 exposure has a much more significant economic impact on credit spread than the past pandemics. We also find firm-level pandemic risk reduces CDS spread slope and increases credit spread volatility which indicates that pandemic risk tends to manifests as as short-term shock that results in short term credit spreads trading higher relative to longer term credit spreads and more uncertainty around credit status.

Hierarchical PCA and Applications to Portfolio Management

Asset returns in a multivariate market in which securities are grouped into sectors or blocks (e.g. GIC sectors, derivatives associated with different underlying assets). It is widely known that risk-factors derived from PCA beyond the first eigenportfolio are difficult to interpret (the “identification problem”) and hence to use in 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 practically no loss of information with respect to PCA, in the case of equities (constituents of the S&P 500), and the associated risk-factors admit simple interpretations. The model can also be used in context 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).

The risk management implications of using end of day consensus pricing for single name CDS

When markets are opaque, market participants rely to a large extent on end-of-day consensus prices published by service providers; such as in the case of the single name credit default swaps (CDS) market. End-of-day consensus CDS prices are critical for valuation and risk management purposes, since profits and losses of inventory positions can be determined by marking to market using end-of-day consensus prices. Deviations between end-of-day prices and intraday quotes can occur due to many factors, including market illiquidity. This paper identifies determinants of such deviations, lays out the times when they can occur, and examines the impact of these deviations for risk management purposes. End-of-day consensus prices are representative of average and median intraday quotes; however, in periods of high volatility and market distress, end-of-day prices can notably differ from actual intraday quotes. Such analysis can allow market participants to better rely on end-of-day consensus prices during normal market conditions.

Excess liquidity premia of single-name CDS vs iTraxx/CDX spreads: 2007-2017

PurposeThe aim of this research is twofold. First, we study average levels of liquidity for long-run through-the-cycle periods, which potentially allow eliminating procyclicality from risk parameters used for expected credit-loss calculations. Second, we investigate to what extent the relative illiquidity of individual credit default swap (CDS) contracts affects their spreads in comparison with the respective CDS indices.Design/methodology/approachBased on the iTraxx Europe CDS index covering European firms and the CDX North America CDS index covering US firms, as well as on individual CDS transactions involving the reference entities constituting these two benchmark indices, we investigate the excess liquidity premia in spreads of the single-name CDS contracts over the spreads of the iTraxx and CDX indices over 2007-2017.FindingsFirst, single-name CDS excess liquidity premia depend on CDS contract maturity. Second, the long-run average spread of a benchmark index may stay as low as three-fourths of the respective long-run average of the mean of the single-name CDS spreads, meaning that the excess liquidity premium may be as high as one-fourth of the firm-specific CDS spread. Third, the term structure of the excess liquidity differs between the Europe and North America geographies. Fourth, on average, the excess liquidity premia in the single-name CDS spreads over the respective CDS indices diminish with increasing maturities of CDS contracts.Originality/valueNo previous research addresses differences between the liquidity component in a benchmark CDS index spreads and the mean spread averaged across the constituents of the index. Our work fills this gap.

The Impact of Central Clearing on the Pricing of Sovereign Credit Default Swaps

Central counterparty clearing houses (CCPs) are highly regulated intermediaries and risk management providers for OTC transactions. This paper analyzes the impact of CCP clearing on the pricing of sovereign single-name credit default swaps (CDS) using a global sample between 2010 and 2017. The results indicate that a large portion of daily CCP cleared contracts makes CDS spreads insignificant to counterparty risk and thus mitigates a major source of systemic risk in the CDS market. In contrast, CCP clearing has no significant effect on CDS market liquidity. Moreover, CDS spreads are mainly driven by local factors as opposed to global factors.