Swap Market Research Articles

FROM BID-ASK CREDIT DEFAULT SWAP QUOTES TO RISK-NEUTRAL DEFAULT PROBABILITIES USING DISTORTED EXPECTATIONS

Risk-neutral default probabilities can be implied from credit default swap (CDS) market quotes. In practice, mid-CDS quotes are used as inputs, as their risk-neutral counterparts are not observable. We show how to imply risk-neutral default probabilities from bid and ask quotes directly by means of formulating the CDS calibration problem to bid and ask market quotes within the conic finance framework. Assuming the risk-neutral distribution of the default time to be driven by a Poisson process we prove, under mild liquidity-related assumptions, that the calibration problem admits a unique solution that also allows to jointly calculate the implied liquidity of the market.

Countercyclical Foreign Currency Borrowing: Eurozone Firms in 2007–09

AbstractUsing syndicated loan‐level data, we document and explain the causes and implications of a new and surprising stylized fact. In the midst of the financial crisis, dollar borrowing by leveraged Eurozone (EZ) corporates rose dramatically relative to their euro borrowing. We show that this resulted from a shift from EZ to non‐EZ banks, mainly U.S. banks. This was combined with an increase in the proportion of dollar lending by non‐EZ banks, explained by a rise in the relative cost of euro wholesale funding and the disruptions in the FX swap market. Non‐EZ banks thus dampened the 2007–09 credit crunch in Europe.

Testing the expectations hypothesis and explaining the determinants of term premia: evidence from the Indian money market

ABSTRACT The pure expectations hypothesis states that the current yields on bonds with different maturities reflect investor expectations of future interest rates. Analysing the short-term inter-bank rates in a Vector Error Correction Model (VECM), the study could reject the pure as well as the general expectations theory in case of the 1 month and 3 months rates but not in case of 14 day rates. The term premia is found to be time-varying. The study attempts to quantify and decompose the term premia, inherent in the money market rates. The study uses the market spreads derived from the swap market, T-Bills, and CD markets to understand the level of decomposition of the term premia. A latent factor model was used to break down the term premia and decompose the same into credit and liquidity risk factors by using information from related money market instruments.

The asymmetric impact of the pandemic crisis on interest rates on public debt in the Eurozone

The outbreak of Covid-19 has played the role of a ‘game changer’ in the way countries of the Eurozone have faced the economic consequences of the pandemic crisis. This paper investigates what has happened to the interest rates of the sovereign bond in selected countries of the Eurozone during 2020. While the pandemic crisis can be interpreted as a symmetric shock, we found some important asymmetric consequences both in the sovereign bond market and the credit default swap market. Even though the European Central Bank (ECB) has played a fundamental role in easening tensions, especially with the announce of the Pandemic Emergency Purchase Programme (PEPP), countries with a higher pre-Covid level of the debt-to-GDP ratio have been found to undergo a significant jump in interest rates and a greater perceived risks of default. Important policies implications emerge in relation to the future role of the ECB.

Uncovering the mesoscale structure of the credit default swap market to improve portfolio risk modelling

One of the most challenging aspects in the analysis and modelling of financial markets, including Credit Default Swap (CDS) markets, is the presence of an emergent, intermediate level of structure standing in between the microscopic dynamics of individual financial entities and the macroscopic dynamics of the market as a whole. This elusive, mesoscopic level of organisation is often sought for via factor models that ultimately decompose the market according to geographic regions and economic industries. However, at a more general level, the presence of mesoscopic structure might be revealed in an entirely data-driven approach, looking for a modular and possibly hierarchical organisation of the empirical correlation matrix between financial time series. The crucial ingredient in such an approach is the definition of an appropriate null model for the correlation matrix. Recent research showed that community detection techniques developed for networks become intrinsically biased when applied to correlation matrices. For this reason, a method based on Random Matrix Theory has been developed, which identifies the optimal hierarchical decomposition of the system into internally correlated and mutually anti-correlated communities. Building upon this technique, here we resolve the mesoscopic structure of the CDS market and identify groups of issuers that cannot be traced back to standard industry/region taxonomies, thereby being inaccessible to standard factor models. We use this decomposition to introduce a novel default risk model that is shown to outperform more traditional alternatives.

Credit Transmission, Liquidity, and Bank Capital in Colombia

This document analyses monetary policy effects on transmission of credit interest rates in Colombia with particular attention to the period of global liquidity spurred by the COVID-pandemic during 2020-2022. Challenges for banks operating in Colombia are twofold: they face increasing banking competition (reinforced by FINTECH) and increasing credit risks due to deteriorating macro-financial conditions after a -6.8% real-GDP and an average of 16% in unemployment over 2020. Expected rebound for 2021 looks mild at 4% in real-GDP and staggered unemployment averaging 14%.Credit transmission has been fairly rapid in corporate credits, but slow in consumption loans, given contract prevalence at fix-rates (87% of total) and extensions averaging 6 years in the latter. Gains in credit transmission would require: i) deepening of the swaps market of interest rates, currently focused at OTC instead of the registered market; and ii) increasing the floating portion related to the IBR (bid-market over the central bank repo-window), currently covering only 12% of the portfolio. This would be the Colombian version of the worldwide move from LIBOR into SFAR. However, this deepening of capital markets in Colombia hinge crucially in preserving the “investment grade” status over 2021-2022, currently facing unanimous “negative outlook” from the rating agencies. Finally, compression of financial wedges, increasing credit risks, and higher liquidity-capital requirements (over 2021-2024, under Basle III) represent significant challenges for banks operating in Colombia. Financial Superintendence recently reported Colombia as complying with Basle III, after the transition period of 2016-2019, joining the 42% of LATAM countries in that category.

The Homogeneous Properties of Automated Market Makers

Automated market makers (AMM) have grown to obtain significant market share within the cryptocurrency ecosystem, resulting in a proliferation of new products pursuing exotic strategies for horizontal differentiation. Yet, their theoretical properties are curiously homogeneous when a set of basic assumptions are met. In this paper, we start by presenting a universal approach to deriving a formula for liquidity provisioning for AMMs. Next, we show that the constant function market maker and token swap market maker models are theoretically equivalent when liquidity reserves are uniform. Proceeding with an examination of AMM market microstructure, we show how the non-linear price effect translates into slippage for traders and impermanent losses for liquidity providers. We proceed by showing how impermanent losses are a function of both volatility and market depth and discuss the implications of these findings within the context of the literature.

Creating a market for price swaps: Case study of an innovative risk management instrument in the Belgian-Dutch pear market

While the benefits of using futures to manage price risk are widely recognised, only certain groups of farmers have suitable futures at their disposal. This paper discusses an innovative instrument, developed in the Belgian-Dutch pear market, that provides an alternative to futures markets by creating a market for price swaps. Thus, the instrument provides some benefits of market-traded derivatives (like futures) while remaining a relatively simple instrument, which requires fewer market transactions. The paper describes key properties of the swap contracts and the platform used to trade them. In addition, it compares the conditions required for establishing price swap markets and futures markets. Thus, our study informs the design of similar risk management instruments for commodities and contexts where futures are absent.

The Making of Zero Curves

Risk-free rates are ubiquitous in finance, even more after the Cox-Ross [6] principle of risk-neutral valuation for derivatives. Simple arbitrage shows that they can be negative only if considered net of the storage cost of money. The phase-out of Libor, its replacement by overnight reference rates, and the way they are used to determine zero rates make this paper’s topic relevant. Similarly to the federal funds rate, which is a weighted average of the rates in brokered transactions (with weights being determined by the size of the transaction), we advocate the construction of transaction-weighted zero curves. In particular, we highlight the role of risk-free zero curves defined by the ISDA CDS standard model in order to standardize the quotes in the market for credit default swaps.

Clear(ed) decision: The effect of central clearing on firms’ financing decision

Does derivative market regulation affect real economic outcomes? We investigate this question in the setting of the central counterparty (CCP) clearing reform on the corporate credit default swap (CDS) market. Exploiting the staggered introduction of CCP clearing to CDS contracts -- an insurance against firm default -- we uncover adverse real economic consequences for affected (non-financial) firms. Firms whose CDS contract is eligible for clearing with the monopolist CCP lose debt funding, shrink their balance sheet, cut employment and become less profitable. We theoretically motivate two channels through which the market environment of derivatives can affect firms’ debt funding situation: the hedging channel, working through increased absolute prices of cleared compared to non-cleared CDS contracts making hedging more expensive; and the arbitrage channel, working through increased relative prices of cleared CDS contracts compared to the associated corporate bonds making the bond market less attractive. We find suggestive empirical evidence for both channels being active in reducing demand for affected firms' corporate bonds.

Liquidity risk: Intraday liquidity and price spillovers in euro area sovereign bond markets

The purpose of this paper is to determine the cross-market liquidity and price spillover effects across euro area sovereign bond markets. The analysis is carried out with the constructed minute frequency order-book dataset from 2011 until 2018. This derived dataset covers the six largest euro area markets for benchmark 10-year sovereign bonds. To estimate the cross-market spillover effect between sovereign bonds, it was decided to use the empirical approach proposed by Diebold and Yilmaz (2012) and combine it with the vector error correction model (VECM). We also employed the panel regression model to identify why some bond markets had a higher spillover effect while others were smaller. The dependent variable was the daily average spillover effect of a particular bond. As the spillover effects vary highly across different bonds, country-specific fixed effects were used, and the clustered standard errors were calculated for robustness reasons. Lastly, the cross-market spillovers were analyzed daily to compare them with the results of the model with intraday data. The analysis was performed with rolling 100-day window variance decompositions and a 10-day forecast horizon for six sovereign bonds and the overnight indexed swap (OIS) market. The results of the created time-series model revealed that intraday cross-market spillovers exist but are relatively weak, especially in the case of liquidity spillovers. As the cross-market linkages became much more robust with the model using daily data, the liquidity or price disbalances between different markets are usually corrected on longer intervals than minutes. Distance between countries is the most important explanatory variable and is negatively linked to the magnitude of both liquidity and price spillovers. These findings should be of particular interest to bond market investors, risk managers, and analysts who try to scrutinize the liquidity and price transmission mechanism of sovereign bonds in their portfolios.

Convenience Yield and Real Exchange Rate Dynamics: A Present-Value Interpretation

In this paper, we empirically investigate the relationship between the convenience yield of government bonds and the real exchange rates using monthly data spanning from 1999 to 2018. We extend the conventional models, based on present-value relationship between real exchange rate and economic fundamentals, while explicitly considering the role of the convenience yield. Empirical results suggest that our present-value models are able to capture the dynamic properties of the real exchange rate documented in literature, including high persistence, and excess volatility and co-movement compared with real interest rate differentials. We also find the sum of expected convenience yields significantly drives real exchange rate movements. Moreover, we found that foreign exchange swap market friction also plays a role in explaining real exchange rates. Finally, we identified a deviation with regard to the monetary policy rule, and found that monetary policy at the zero lower bound is also significant for yen--dollar real exchange rate modeling.

Credit default swap market retrospective: observations from the 2008–9 financial crisis and the onset of the Covid-19 pandemic

Global credit default swap (CDS) markets experienced unprecedented whipsaw spread realizations during March and April 2020. While the main source of market uncertainty was the Covid-19 pandemic, the March 2020 oil price war between Saudi Arabia and Russia added “fuel to the fire”. In this paper credit market fluctuations, measured by the levels of the main and most heavily traded index instruments, are analyzed and compared with the analogous index realizations during the 2008–9 financial crisis. The Covid-19 credit market fluctuations exceeded those during the financial crisis in terms of daily amplitudes and the rates at which spread tightening followed the initial spread widening. The fast-moving credit markets led to record index trading and clearing activity at all three major CDS clearinghouses. Clearinghouse volumes and general clearing trends during the onset of the Covid-19 pandemic are presented in the context of the observed explosion in market volatility. The continuous development and investment in central clearing over the last 10 years greatly contributed to the financial stability of the CDS markets during the Covid-19 crisis, providing increased market transparency, capital efficiency and robust risk management services in the presence of record daily volumes, open interest levels and mark-to-market payments.

Issuance and Valuation of Corporate Bonds with Quantitative Easing

After the announcement of the European Central Bank’s corporate quantitative easing program, non-financial corporations timed the bond market by shifting their issuance toward bonds eligible for the program. However, issuers of eligible bonds did not increase total issuance compared to other issuers; nor did they experience different economic outcomes. Instead, the announcement produced substantial spillover effects on risk premia. Credit risk premia declined, both in the corporate bond market and in the default swap market, whereas the valuation of eligible bonds did not change relative to comparable ineligible bonds. Firms took advantage of reduced risk premia by issuing riskier bond types. Using a novel and comprehensive dataset of corporate bonds in the euro area, we document how firms substituted across bond characteristics, and we find evidence of their intention to time the market. Our model indicates corporate market timing is instrumental in allowing quantitative easing to produce spillover effects. JEL Classification: G32, G12, E52, E58, E44

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.

Is the Tone of Risk Disclosures in MD&As Relevant to Debt Markets? Evidence from the Pricing of Credit Default Swaps*

ABSTRACTThis paper examines whether the tone of corporate textual disclosures related to risk and uncertainty conveys relevant information to the credit default swap (CDS) market. Prior studies largely focus on the amount of risk disclosures and provide inconclusive evidence on the usefulness of risk disclosures for investors in assessing firm risk. Using a large sample of textual risk disclosures in the Management's Discussion and Analysis (MD&A) section of 10‐K and 10‐Q filings, I predict and find that the change in CDS spreads over the three‐day window surrounding the 10‐K/Q filing date is positively associated with the pessimism of the language used in the risk disclosures. I conduct several analyses to show that the effect of the tone of risk disclosures is distinguishable from that of the amount of such disclosures. Cross‐sectional analyses reveal that the CDS market reaction to the tone of MD&A risk disclosures is more pronounced for reference entities closer to default, consistent with creditors' particular concern about downside risk. Further, the CDS market reacts more significantly to the tone of MD&A risk disclosures for reference entities with a weaker information environment. Overall, these results support the view that the tone of textual risk disclosures in MD&As has information content for investors in the CDS market in particular and debt markets in general. My findings improve the understanding of textual risk disclosures by showing that the tone and the amount of such disclosures have different implications for debt market investors' risk perceptions.

Risk Transfer with Interest Rate Swaps

AbstractThis paper proposes Entity‐Netted Notionals (ENNs) as a metric of interest rate risk transfer in the interest rate swap (IRS) market. Unlike the ubiquitous metric of notional amount, ENNs normalize for risk and account for the netting of longs and shorts within counterparty relationships. Using regulatory data for U.S.‐reporting entities, the size of the market measured by notional amount is $231 trillion, but, measured by ENNs, is only $13.9 trillion 5‐year swap equivalents, which is the same order of magnitude as other large U.S. fixed income markets. This paper also quantifies the size and direction of IRS positions across and within various business sectors. Among the empirical findings are that 92% of entities using IRS are exclusively long or exclusively short. Hence, the vast majority of market participants are prototypical end users, and the extensive amount of netting in the market is attributable to the activity of relatively few, larger entities. Finally, some sector‐specific empirical findings are inconsistent with widespread, prior beliefs. For example, pension funds and insurance companies are typically thought to be long IRS to hedge their long‐term liabilities, and these sectors are indeed net long, but approximately 50% of individual entities in these sectors are actually net short.

Small and Vulnerable

We provide broad-based evidence of a firm size premium of total factor productivity (TFP) growth in Europe after the Global Financial Crisis. The TFP growth of smaller firms was more adversely affected and diverged from their larger counterparts after the crisis. The impact was progressively larger for medium, small, and micro firms relative to large firms. It was also disproportionally larger for firms with limited credit market access. Moreover, smaller firms were less likely to have access to safer banks: those that were better capitalized banks and with a presence in the credit default swap market. Horseraces suggest that firm size may be a more important and robust vulnerability indicator than balance sheet characteristics. Our results imply that the tightening of credit market conditions during the crisis, coupled with limited credit market access especially among micro, small, and medium firms, may have contributed to the large and persistent drop in aggregate TFP.

Corporate Payout Policy and Credit Risk: Evidence from Credit Default Swap Markets

We examine whether and how payout policy affects credit risk using evidence from the credit default swap (CDS) market. CDS spreads increase substantially in response to announcements of dividend cuts, especially during recessions and among firms experiencing financial distress. CDS spreads also react more strongly to permanent and less anticipated dividend cuts. The size of the CDS reaction is more pronounced for financial firms, which are inherently more opaque. In contrast, CDS spreads react weakly to dividend raises and share repurchases. The results show that the information effect of dividend changes dominates the wealth-transfer effect. This paper was accepted by Kay Giesecke, finance.

An Incentive Mechanism Model of Credit Behavior of SMEs Based on the Perspective of Credit Default Swaps

The rapid development of credit default swap (CDS) market has changed the manner of credit risk management of banks to some extent and has had a new influence on the bank-enterprise credit model. In this study, the credit financing process of credit risk in small- and medium-sized enterprises (SMEs) gathers within a bank, which makes it difficult for SMEs to raise funds. On the basis of the perspective of CDS, we construct an incentive game model of bank-enterprise credit behavior and analyze the influence mechanism of the credit financing of SMEs on CDS contract coupon rate, CDS payout ratio, bank-enterprise credit effort, and loan recovery rate when considering CDS. The result shows that the CDS contract leads to insufficient supervision after a bank loan, the moral hazard of the SMEs rises, and the probability of credit default events increases. In addition, in view of CDS, the SMEs can access more credit funds.