Credit Spread Volatility Research Articles

Estimating actual probability of default from structural models

In this paper, we study the probability of default, the credit default swap (CDS) implied probability of default, and the estimated actual probability of default from the structural models. We first show that the conditional risk-neutral probability of default is totally different from the CDS implied probability of default, and the CDS implied probability of default provides biased estimation of a corporation’s actual probability of default. Hence, the common belief that the CDS implied probability of default gives unbiased (or reliable) estimations of the firm’s probability of default is false. Furthermore, we use the credit spread risk premium as the difference of the physical measure and the risk-neutral measure of the credit spread to estimate the actual bond spread, and relate the credit spread risk premium in terms of the market price of risk and the credit spread volatility. Using the credit spread volatility and the risk-neutral credit spread and the market price of risk in hybrid HPD model, we obtain the estimated actual probability of default in a structural model. The estimated actual probability of default would be useful for credit rating agencies, investors, credit risk managers and regulators.

Lending relationships and labor market dynamics

Motivated by a negative link between credit spreads and labor force participation (LFP) and a positive link between these spreads and unemployment over the business cycle, we study the role of LFP as an amplification mechanism of financial shocks in a labor search model with endogenous LFP, lending relationships, and credit-market disruptions. Amid aggregate productivity and financial shocks that replicate the empirical volatility of LFP and credit spreads, the model produces highly volatile unemployment and vacancies, countercyclical credit spreads and unemployment, and procyclical LFP. When we quantitatively match the cyclical behavior of credit spreads, the interaction between endogenous LFP and financial shocks gives rise to much sharper vacancy fluctuations and plays a key role in generating quantitatively factual cyclical labor market dynamics.

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.

Impact of Readability on Corporate Bond Market

This paper investigates the impact of annual report readability on the corporate bond market. My findings indicate that in the US corporate bond market, firms with less readable annual reports tend to have higher credit spreads, higher credit spread volatilities, higher transaction costs, higher transaction costs volatility, smaller trade size, higher number of trades and higher number of trades volatility. This paper also provides the first answers to the question as to whether annual report readability matters to international market participants in the corporate bond market. My findings provide evidence that in the EUR corporate bond market, firms with more readable annual reports are associated with lower credit spreads.

Impact of Readability on Corporate Bond Market

This paper investigates the impact of annual report readability on the corporate bond market. My findings indicate that in the US corporate bond market, firms with less readable annual reports tend to have higher credit spreads, higher credit spread volatilities, higher transaction costs, higher transaction costs volatility, smaller trade size, higher number of trades and higher number of trades volatility. This paper also provides the first answers to the question as to whether annual report readability matters to international market participants in the corporate bond market. My findings show evidence that in the EUR corporate bond market, firms with more readable annual reports are associated with lower credit spreads.

Implications of implicit credit spread volatilities on interest rate modelling

We test seven term structure models in the Heath, Jarrow, and Morton (1992) class in order to find the best representation of the Libor rate in interest rate markets after the credit crunch of 2007. The Libor rate is considered as a risky rate, subject to the credit risk of a generic counterparty whose credit quality is refreshed at each fixing date. We study the volatilities of the credit spreads implicitly obtained from Libor time series. In order to understand how assumed volatility functions affect interest rate curve modelling and asset pricing, we develop a model to estimate basis swap prices through the Monte Carlo simulations. We compare obtained results and individuate systematic relations existing between the basis spread forecast error and both the accuracy in volatility modelling and the accuracy of the Monte Carlo estimates. We analyse and document these relations by defining appropriate pricing error measures.

Implications of Implicit Credit Spread Volatilities on Interest Rate Modelling

We test seven term structure models in the Heath-Jarrow-Morton (1992) class in order to find the best representation of the Libor rate in interest rate markets after the credit crunch of 2007. The Libor rate is considered as a risky rate, subject to the credit risk of a generic counterparty whose credit quality is refreshed at each fixing date. We study the volatilities of the credit spreads implicitly obtained from Libor time series. In order to understand how assumed volatility functions affect interest rate curve modelling and asset pricing, we develop a model to estimate basis swap prices through the Monte Carlo simulations. We compare obtained results and individuate systematic relations existing between the basis spread forecast error and both the accuracy in volatility modelling and the accuracy of the Monte Carlo method. We analyze and document these relations by defining appropriate pricing error measures.

Unemployment and Credit Risk

This paper studies the credit risk implications of labor market fluctuations, by incorporating defaultable debt into a textbook search model of unemployment. In the model, the present value of cash flows that firms extract from workers simultaneously drives unemployment dynamics and credit risk variation. The model generates fat right tails in both unemployment and credit spreads, and their strong co-movement over the business cycle, in line with the historical U.S. data from 1929 to 2015. Quantitatively, the model reasonably replicates the level, volatility and cyclicality of credit spreads. Overall, the paper highlights labor market fluctuations as an important macroeconomic driver of credit risk variation.

The EU Ban on Uncovered Sovereign Credit Default Swaps: Assessing Impacts on Liquidity, Volatility, and Price Discovery

During the recent financial crisis, regulatory authorities banned short positions in various financial markets in attempts to moderate pressure from what were felt to be unfavorable, unwarranted, and largely speculative, price changes. Suppression of undesirable price moves was extended to the realm of sovereign debt in November 2012, when the European Union prohibited “naked” purchases of credit default swaps (CDSs) on sovereign bonds. Buying CDS protection is deemed to be naked if the buyer is not doing so to protect an existing long position in the underlying bonds. Academic theory, and empirical evidence from similar bans on short sales in other markets, suggests that such interference in a competitive financial market generally doesn’t work very well: Market participants find ways around the rule; liquidity is reduced in the constrained market; information flow is degraded and prices can become biased because investors with unfavorable beliefs are eliminated from the market; and volatility may increase. Using a “diff-in-diffs” strategy of contrasting the effect on CDS spreads in the 28 affected countries with those in the 56 unconstrained countries as this regulation went into effect, Silva, Vieira, and Vieira show that credit-spread volatility was reduced by the ban, but liquidity was hurt as bid–ask spreads widened and open interest declined. They also find that price informativeness was reduced, in particular by lengthening the time it took for negative information to enter CDS spreads.

A defaultable HJM modelling of the Libor rate for pricing Basis Swaps after the credit crunch

A great deal of recent literature discusses the major anomalies that have appeared in the interest rate market following the credit crunch in August 2007. There were major consequences with regard to the development of spreads between quantities that had remained the same until then. In particular, we consider the spread that opened up between the Libor rate and the OIS rate, and the consequent empirical evidence that FRA rates can no longer be replicated using Libor spot rates due to the presence of a Basis spread between floating legs of different tenors. We develop a credit risk model for pricing Basis Swaps in a multi-curve setup. The Libor rate is considered here as a risky rate, subject to the credit risk of a generic counterparty whose credit quality is refreshed at each fixing date. A defaultable HJM methodology is used to model the term structure of the credit spread, defined through the implied default intensity of the contributing banks of the Libor corresponding to a chosen tenor. A forward credit spread volatility function depending on the entire credit spread term structure is assumed. In this context, we implement the model and obtain the price of Basis Swaps using a numerical scheme based on the Euler–Maruyama stochastic integral approximation and the Monte Carlo method.

Wrong Way Risk Done Right

We present an arbitrage-free valuation framework for the counterparty exposure of credit derivatives portfolios based on a Clayton dynamical default dependency approach. The method is able to capture consistently the effects of credit spread volatility and credit correlations. By introducing fast semi-analytical approximations of the conditional survival probabilities we demonstrate how the proposed approach can be used to handle large size portfolios of CDS under financially realistic models of default intensities.

CVA with Wrong Way Risk: Sensitivities, Volatility and Hedging

We propose a CVA model capturing the wrong way risk that is not product-specific and is suitable for large-scale computations. The model is based on a doubly stochastic default process with the default intensities proxied by credit spreads. Unlike in other models, the CVA is a function of the credit spread volatility and not only of its current level. For different exposure structures, we show how credit-market correlation affects the CVA level, its sensitivities to credit and market factors, its volatility and the quality of hedging. The wrong way risk is most significant for exposures highly sensitive to the market volatility in a situation when credit spreads are at moderate levels but both the market factors and credit spreads are volatile. In such conditions, ignoring credit-market correlations results in important CVA mispricing. We show that taking into account market conditions and, in particular, credit-market correlations is essential in designing a CVA hedging strategy. While the benefits from hedging are always magnified in the situation of the wrong way risk, the right way exposure case is more delicate: only a well-designed mix of credit and market hedges can bring volatility down. Our results raise doubts on the Basel III policy of recognizing credit but not market hedges for computing the CVA volatility capital charge.

Comment on “Fundamentally Wrong: Market Pricing of Sovereigns and the Greek Financial Crisis”

Gibson’s et al. (2013) provide evidence that credit ratings have exerted an independent influence on credit (sovereign) spreads for Greece beyond that implied by economic fundamentals. Based on the Markov Regime-switching model of Hamilton (1989), we show that this happens during the recent financial crisis regime, characterized by a higher mean and volatility of credit spreads. It is also true for Ireland and Portugal, also bailed out by their EU partners and IMF. We show that, for Greece and Portugal, the shift of credit spreads to their higher mean-volatility regime occurred before the collapse of Lehman brothers, thus discounting a higher price of sovereign credit risk for these two countries. In contrast to Ireland, this regime shift has not been triggered by a rating downgrades for Greece and Portugal. In this higher volatility regime, credit ratings seem to significantly influence future changes in credit spreads independently of economic fundamentals, for Greece and Portugal. For Ireland, they constitute the main factor of determining credit spreads.

Rare Disasters, Credit, and Option Market Puzzles

We embed systematic default, procyclical recovery rates, and external habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy can simultaneously explain several key empirical regularities in equity, credit, and options markets. Our model captures the empirical level and volatility of credit spreads, generates a flexible credit risk term structure, and provides a good fit to a century of observed spreads. The model also matches high-yield and collaterized debt obligation tranche spreads, equity market moments, and index option skewness. Finally, our model implies a time-varying relationship between bond and option prices that depends on the state of the economy and that explains the conflicting empirical evidence found in the literature. This paper was accepted by Jerome Detemple, finance.

PRICING COUNTERPARTY RISK INCLUDING COLLATERALIZATION, NETTING RULES, RE-HYPOTHECATION AND WRONG-WAY RISK

This article is concerned with the arbitrage-free valuation of bilateral counterparty risk through stochastic dynamical models when collateral is included, with possible rehypothecation. The payout of claims is modified to account for collateral margining in agreement with International Swap and Derivatives Association (ISDA) documentation. The analysis is specialized to interest-rate and credit derivatives. In particular, credit default swaps are considered to show that a perfect collateralization cannot be achieved under default correlation. Interest rate and credit spread volatilities are fully accounted for, as is the impact of re-hypothecation, collateral margining frequency, and dependencies.

Rare Disasters and Credit Market Puzzles

We embed systematic default, pro-cyclical recovery rates and habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy can simultaneously explain several key empirical regularities in equity, credit, and options markets. Our model captures the empirical level and volatility of credit spreads, generates a fl‡exible credit risk term structure, and provides a good fi t to a century of observed spreads. The model also matches high-yield and CDO tranche spreads, equity market moments, and index option skewness. Finally, our model implies a time-varying relationship between bond and option prices that depends on the state of the economy and that explains the con‡flicting empirical evidence found in the literature.

Credit Risk and Disaster Risk

Credit spreads are large, volatile and countercyclical, and recent empirical work suggests that risk premia, not expected credit losses, are responsible for these features. Building on the idea that corporate debt, while safe in ordinary recessions, is exposed to economic depressions, this paper embeds a trade-off theory of capital structure into a real business cycle model with a small, exogenously time-varying risk of economic disaster. The model replicates the level, volatility and cyclicality of credit spreads, and variation in the corporate bond risk premium amplifi es macroeconomic ‡fluctuations in investment, employment and GDP.

CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms

This paper attempts to explain the credit default swap (CDS) premium by using a novel approach to identify the volatility and jump risks of individual firms from a unique dataset of high-frequency CDS spreads. I find that the volatility risk alone explains 55% of the variation in CDS spread levels, whilst the jump risk alone explains 45%. After controlling for credit ratings, macroeconomic conditions and firms’ balance sheet information the model explains 93% of total variation. In the cross-section I find that volatility risk can explain 63% of the variation in the credit spreads whilst jump risk explains 55%. For the CDX index I find that the volatility risk alone explains 22% of the variation in the CDX index levels, while the jump risk alone explains 25%. The results reported in this paper suggest that the time-varying volatility risk premium and jump risk premium of the credit spreads may play a more important role than previously attributed to them.

Rare Macro Disasters in Credit and Option Markets

We show that the slight possibility of a macroeconomic disaster of moderate magnitude can explain important features across credit, option, and equity markets. Our consumption-based equilibrium model captures the empirical level and volatility of credit spreads, generates a flexible credit term structure and provides a good fi t to a century of observed spreads. The model matches the widespread volatility smirk in index options as well as the first two moments of government bond and equity market returns. Our model reveals a dynamic relationship between credit and option markets that helps explain the inconclusive evidence found in the empirical literature when regressing credit spreads on the option smirk.

CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms

CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms