Swap Market Research Articles

Hungarian forint FX swap spreads during and beyond crisis times

Incentivised by a wide range of research discussing mispricing in USD related swap markets, the paper aims at discovering the factors contributing to the deviation of the 3-month FX swap points in the EURHUF and USDHUF market from their CIP based values primarily between the period January 2008 and December 2018 and with an extension to the end of 2021 using daily and monthly Bloomberg quotes. The period examined can be divided into three plus one subperiods as concerns FX swap spreads, largely determined by the effects of the global financial crisis and the volume of FX loans. Apart from the most important classes of variables explaining FX swap spreads, counterparty, funding and market liquidity risk indicators, the literature identifies, policy variables were also involved in the analysis. During and in the aftermath of the 2008 global financial crisis, the MNB applied various kinds of FX swap tenders to ease FX liquidity tensions in the Hungarian interbank market, and continued providing such operations even after the conversion of household FX loans to domestic currency. The results of VARX estimations suggest that indicators of market and liquidity tension, counterparty risk mostly positively contributed to the widening of FX swap spreads, in addition, policy intervention had a spread dampening impact throughout most of the period. The paper confirms that central bank FX swap market participation can mitigate mispricing especially in turbulent times.

Standardization, transparency initiatives, and liquidity in the CDS market

We investigate liquidity changes in the credit default swap (CDS) market around two events that increased market transparency and standardization during the Great Financial Crisis: the dissemination of CDS positions starting in November 2008, and the implementation of the Small Bang in July 2009. We build an econometric model based on bid and ask quotes to measure liquidity in thinly traded CDSs. We find that, after the release of CDS positions, the market-wide deterioration in liquidity is less important for banks, consistent with information revelation alleviating systemic risk uncertainty. The Small Bang also improved liquidity, particularly for more illiquid CDSs.

Proxying credit curves via Wasserstein distances

Credit risk plays a key role in financial modeling, and financial institutions are required to incorporate it in their pricing, as well as in capital requirement calculations. A common manner to extract credit worthiness information for existing and potential counterparties is based on the Credit Default Swap (CDS) market. Nonetheless, not all counterparties of a financial institution have (liquid) CDSs traded in the market. In this case, financial institutions shall employ a proxy methodology to estimate the default probabilities of these counterparties. Starting from the intersection methodology for credit curves, in this article we investigate whether it is possible to construct proxy credit curves from CDS quotes by means of (weighted) Wasserstein barycenters. We show how, under simple and common assumptions, this revised methodology leads to elementary and intuitive formulae to calculate distances between CDS-implied default probability distributions. Further, we illustrate how to use this information to construct proxy CDS quotes.

The relevance of GAAP vs. non-GAAP net assets to creditors: An examination of the credit default swap market

Recent empirical research examines the credit relevance of non-GAAP net assets in low and high default risk settings and finds that the credit relevance of non-GAAP net assets increases when default risk is high (Eberhart, Maxwell, & Siddique 2008; Plumlee Xie, Yan, & Yu 2015). Using the implication of debt contracting theory (Kothari, Ramanna, & Skinner 2010), we extend this research to compare and contrast the credit relevance of GAAP and non-GAAP net assets in low and high default risk settings. We evaluate the change in reliance creditors place on GAAP net assets relative to that placed on non-GAAP net assets. Using data from the credit default swap (CDS) market, we find that the reliance creditors place on GAAP net assets, relative to the reliance placed on non-GAAP net assets, increases with increases in the probability of default. These results contribute to the growing literature examining the relevance of information beyond that provided on the balance sheet.

Sovereign green bond and country value and risk: Evidence from European Union countries

AbstractThe sovereign green bond market has been growing rapidly worldwide since its debut in 2016. The study investigates the empirical response of the stock and credit default swap (CDS) market to green bond issuance by 10 EU countries during the period 2016–2021. We document that the issuance of a green bond is regarded by the investors as reflecting as value‐enhancing and risk‐reducing behavior by EU countries. The issuance of sovereign green bond provides a strong signal of the country's involvement to a low‐carbon economy by increasing the social and reputational benefits. This effect is even more evident during the pandemic crisis. The reaction of stock and CDS market is driven by several factors such as bond and country characteristics. Overall, our findings suggest that the sovereign issuance of green bonds acts as mitigation mechanism for country risk.

Predictability of sovereign CDS: permutation entropy method

With the expansion of sovereign debt default swap (CDS) market, gradually attention has been paid to sovereign CDS forecasting research. This paper compares the predictability of sovereign CDS between China and USA by using the permutation entropy approach and G(M) test. Besides, sliding window technique has been applied for time-varying predictability analysis. The empirical results suggest that USA sovereign CDS is more predictable than China, and the predictability of USA sovereign CDS has changed more over time. The research result provides guidance for the sovereign CDS forecast modelling.

Do Firms Benefit from Carbon Risk Management? Evidence from the Credit Default Swaps Market

Do Firms Benefit from Carbon Risk Management? Evidence from the Credit Default Swaps Market

Do Firms Benefit from Carbon Risk Management? Evidence from the Credit Default Swaps Market

Do Firms Benefit from Carbon Risk Management? Evidence from the Credit Default Swaps Market

Household Mobility across Distance and Neighborhoods: The Role of the Rental Swap Market

Household Mobility across Distance and Neighborhoods: The Role of the Rental Swap Market

The collateral rule: Evidence from the credit default swap market

In this paper, we explore a novel dataset of daily credit default swap (CDS) positions cleared by the largest CDS clearinghouse along with posted margins to study how collateral varies with portfolio risks and market conditions. Contrary to many theoretical models, where collateral constraints follow Value-at-Risk rules, we find strong evidence that collateral requirements are set an order of magnitude larger than what Value-at-Risk rules imply. The panel variation in collateralization rates is well captured by measures of extreme tail risks. We develop a model of endogenous collateral, which explains the conservativeness of collateral levels through disagreement about extreme states.

Impact of the COVID-19 Pandemic on the US Credit Default Swap Market

The COVID-19 pandemic affected the US economy at different levels. Since credit default swaps can be viewed as a default probability indicator, the article shows the credit default swap market perspective on how the US economy was hit by the pandemic. Forecasting models are built to estimate the predictability of the CDS market sectors during the pandemic, i.e., manufacturing, energy, banks, consumer goods, and services and financial sector excluding banks. Econometric tests are applied to check the uniqueness of credit default swap market sectors after the declaration of the pandemic. The results indicate that the financial sector excluding banks performed uniquely during the pandemic; i.e., the predictability of this sector dropped significantly, and the Chow breakpoint test and Wald coefficient test can identify the shift in the data after declaration of the pandemic.

FX Swap Valuation As a Cost of Filling Dollar Funding Gap: A Hierarchical and Dealer-Centric Perspective

This paper constructs a model of the FX swap valuation, the cost of synthetic dollar borrowing, based on the dealers’ behavior and the hierarchy of international finance. In this model, three fundamentals- market-making costs (measured by dealers’ bid-ask spreads), dollar funding liquidity risk (measured by CIP deviation), and the FX swap market liquidity (measured by the dealers’ competition)- derive the valuation of FX swap. The goal is to understand the financial instability spillovers between FX swaps and offshore US-Dollar funding markets through the “dealers” channel. FX dealers are vital institutions that connect different national monetary jurisdictions in the international monetary system. For currencies where FX turnover is low, market makers are central banks. On the other hand, those dealers are primarily private banks for currencies with the highest FX turnover, such as the US dollar. Nevertheless, studying the “dollar funding gap” through the lens of FX swap dealers is a feature that often gets overlooked in International Political Economy scholarship.

The man in the middle—liquidity provision under central clearing in the credit default swap market: A regression discontinuity approach

AbstractIn this study, I analyze the effect of central clearing on credit default swap (CDS) market breadth, depth, and resiliency using a regression discontinuity design. I find evidence for a decrease in absolute bid–ask spreads and bid–ask spread resiliency and an increase in gross trading volume with the beginning of central clearing. However, we observe positive effects of central clearing on CDS market liquidity only for CDS contracts of high fundamental and liquidity risk. Further results indicate that lower trading frictions, that is, counterparty risk and regulatory capital charges, may explain the positive effects of central clearing on CDS market liquidity.

The Perception of Risk Disclosure Characteristics on the Credit Default Swap Market—An Automated Analysis

SYNOPSIS This paper evaluates the associations between credit default swap (CDS) spreads and risk disclosure characteristics, especially the expected qualitative and the expected quantitative impacts of risks on companies' future performance and information on risk management. We find that CDS investors can benefit from information on expected risk impacts and from information on risk management, which is important for the current discussion of the Securities and Exchange Commission (SEC) on risk disclosure regulation. However, for companies, the disclosure of such information can be either beneficial or costly, depending on the initial risk perception of CDS investors prior to the publication of risk disclosures and on the disclosed risk factors. Furthermore, we expand the literature by automatically measuring the mentioned risk disclosure characteristics using dictionary-based approaches.

Enhanced disclosure of credit derivatives, information asymmetry and credit risk

AbstractThis study examines the extent to which enhanced disclosure of credit derivatives [Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) Financial Accounting Standards (FAS) No. 133‐1] reduces information asymmetry and credit derivative sellers who experience a decrease in information asymmetry. I find that bid‐ask spread for credit derivative sellers with positive net protection is reduced in the post‐period, whereas that of sellers with negative net protection and the control groups is not. These results are consistent with the conjecture that market participants use enhanced disclosure to confirm or correct previous expectations about sellers’ credit risk. In addition, results in high versus low institutional groups suggest that bid‐ask spreads reduce in both groups but reduce more in the high institutional group in the post‐period, possibly due to information environment differences. Finally, I investigate the information content of two credit derivative exposure measures: maximum payment amount and fair value. Consistent with McAnally (1996), I find that the maximum payment amount is credit risk‐relevant. Thus, enhanced disclosure facilitates monitoring risk concentration and evaluating credit risk, thereby contributing to the stabilization of capital markets prior to regulation of the credit default swap (CDS) market.

Oil, Foreign Exchange Swaps and Interest Rates in the GCC Countries

ABSTRACT We examine the relationship between oil prices, foreign exchange (FX) swaps and local interbank offered rates in the six Gulf Cooperation Council (GCC) countries. We also investigate the potential hedging and diversification benefits from adding oil positions to portfolios containing GCC FX swaps or interest rate positions. Our findings confirm that oil predicts, and in some cases causes, movements in the various GCC FX swaps and interbank offered rates. We also find that the Saudi FX swap market has the highest volatility spillover from the oil market compared to other markets in the region. Furthermore, our analysis shows a significant change in liquidity conditions in the GCC FX swap markets following a sudden shift in oil prices. Lastly, we document the presence of significant risk reduction benefits from adding oil exposure to portfolios of GCC FX swaps or interest rates with risk going down by at least half in the case of the GCC FX swaps.

FX spot and swap market liquidity spillovers

We study the joint evolution of foreign exchange (FX) spot and swap market liquidity. We find strong co-movement in spot and swap market liquidity conditions and a robust link between FX funding and market liquidity, as gleaned from the pricing of both instruments. This link has strengthened over time. Dealing desks of globally systemically important banks periodically pull back from pricing FX swaps, particularly those that operate closer to regulatory capital or liquidity minimums. While wider spreads attract smaller dealers, liquidity in FX swaps remains impaired, which leads to illiquidity spillovers to the spot market. Our findings suggest that funding liquidity has become a more important driver of spot market liquidity than it used to be.

Counterparty Risk in Over-the-Counter Markets

AbstractWe study trading and risk management decisions of banks in over-the-counter markets, accounting for 2 types of risk: payoff risk from loans and counterparty risk from trading activities. Our model provides empirically supported predictions on the structure of the interbank credit default swap (CDS) market: i) banks with high default probabilities either buy or sell CDS contracts; ii) because of the counterparty risk friction, payoff risk is only partially shared; and iii) safe banks act as intermediaries and help diversify counterparty risk. Banks manage their default probabilities to become creditworthy counterparties, but they do so in a socially inefficient way.

Sovereign CDS Premiums’ Reaction to Macroeconomic News: An Empirical Investigation

We assess the efficiency of the sovereign credit default swap (CDS) market by investigating how sovereign CDS spreads react to macroeconomic news announcements. Contrary to the vast majority of the existing literature, one of our main findings supports the hypothesis that news announcements reduce market uncertainty and, thus, that both better- and worse-than-expected news lower CDS prices during our sample period. In addition, we find that CDS spreads respond differently to the four macroindicators across the three different regions. Our findings might help investors in these areas to interpret the surprises of macronews announcements when making decisions in CDS markets.

Cross-market informed trading in the CDS and option markets

This paper analyzes how informed traders balance leverage and liquidity in making cross-market trading decisions. Our findings are three-fold. Using daily data on the actively traded North American CDX Investment Grade and High Yield indexes from 2010 to 2017, first, we find robust evidence that, when the credit default swap (CDS) market is illiquid, informed traders do not hesitate to exploit their information advantage in the option market, and this manifests mainly for negative credit news. Second, we find that informed trading occurs predominantly in the option market for low-rated firms due to high adverse selection risk in the CDS market. Third, there is strong evidence of informed trading taking place in the CDS market for financial firms and we argue that this is due to the interdealer network through which CDS dealers obtain private information about other financial firms and their privileged position as market makers to be able to disguise their informed trades as ordinary market-making activities. Finally, we propose re-thinking market efficiency and how to advance it in a direction which does not privilege a small circle of financiers or create monopoly while keeping the markets liquid and tranquil at all times.