Sovereign debt renegotiation and credit default swaps

A credit default swap (CDS) contract provides insurance against default. This paper incorporates the contract into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower financing costs for the country. Uncertainty over the insurance payout when the debt is renegotiated explains why in the data, as the output declines, the CDS spread becomes lower than the bond spread. Finally, my results show that the 2012 CDS naked ban, that decreased the levels of CDS for European countries, is a welfare reducing policy.     

Valuation of a Credit Swap of the Basket Type

This article provides a simple model to value a credit swap ofthe basket type. Unlike the previous literature, we considerthe joint survival probability of occurrence times of creditevents in terms of stochastic intensity processes under the assumptionof conditional independence. Based on the joint survival probability,such a credit swap can be valued under the risk-neutral valuationframework. Assuming that the default intensity processes followthe extended Vasicek model with a correlation structure, an analyticexpression of the valuation formula is derived. Some numericalexample is given to demonstrate the usefulness of our model.     

The Co‐movement of Credit Default Swap,Bond and Stock Markets: an Empirical Analysis

We analyse the relationship between credit default swap (CDS), bond and stock markets during 2000–2002. Focusing on the intertemporal co‐movement, we examine monthly, weekly and daily lead‐lag relationships in a vector autoregressive model and the adjustment between markets caused by cointegration. First, we find that stock returns lead CDS and bond spread changes. Second, CDS spread changes Granger cause bond spread changes for a higher number of firms than vice versa. Third, the CDS market is more sensitive to the stock market than the bond market and the strength of the co‐movement increases the lower the credit quality and the larger the bond issues. Finally, the CDS market contributes more to price discovery than the bond market and this effect is stronger for US than for European firms.     

On the Term Structure of Default Premia in the Swap and LIBOR Markets

Existing theories of the term structure of swap rates provide an analysis of the Treasury–swap spread based on either a liquidity convenience yield in the Treasury market, or default risk in the swap market. Although these models do not focus on the relation between corporate yields and swap rates (the LIBOR–swap spread), they imply that the term structure of corporate yields and swap rates should be identical. As documented previously (e.g., in Sun, Sundaresan, and Wang (1993)) this is counterfactual. Here, we propose a model of the default risk imbedded in the swap term structure that is able to explain the LIBOR–swap spread. Whereas corporate bonds carry default risk, we argue that swap contracts are free of default risk. Because swaps are indexed on "refreshed"-credit-quality LIBOR rates, the spread between corporate yields and swap rates should capture the market's expectations of the probability of deterioration in credit quality of a corporate bond issuer. We model this feature and use our model to estimate the likelihood of future deterioration in credit quality from the LIBOR–swap spread. The analysis is important because it shows that the term structure of swap rates does not reflect the borrowing cost of a standard LIBOR credit quality issuer. It also has implications for modeling the dynamics of the swap term structure.     

The dynamics of sovereign yields over swap rates in the Eurozone market

We explore the dynamics of the adjusted swap spread (calculated as the difference between the swap rate and sovereign yields over the credit default swap premium) in the Eurozone market by studying three markets simultaneously: 1) sovereign bonds, 2) credit default swaps (CDS), and 3) swap rates. We find a strong relationship between the markets. Specifically, based on the no-arbitrage argument, we show that the difference between the Euribor and Repo rates is a key driver of the adjusted swap spread. However, illiquidity premiums and systemic risk also play an essential role in times of economic stress and for less creditworthy countries. The findings also shed light on the recent negative swap spreads puzzle in the United States.     

The network structure of the CDS market and its determinants

This paper analyses the network structure of the credit default swap (CDS) market and its determinants, using a unique dataset of bilateral notional exposures on 642 financial and sovereign reference entities. We find that the CDS network is centred around 14 major dealers, exhibits a “small world” structure and a scale-free degree distribution. A large share of investors are net CDS buyers, implying that total credit risk exposure is fairly concentrated. Consistent with the theoretical literature on the use of CDS, the debt volume outstanding and its structure (maturity and collateralization), the CDS spread volatility and market beta, as well as the type (sovereign/financial) of the underlying bond are statistically significantly related—with expected signs—to structural characteristics of the CDS market.     

Large EU banks’ capital and liquidity: Relationship and impact on credit default swap spreads

This paper explores the interrelations between bank capital and liquidity and their impact on the market probability of default. We employ an unbalanced panel of large European banks with listed credit default swap (CDS) contracts during the period 2005–2015, which allow us to consider the impact of the recent financial crisis. Our evidence suggests that bank capital and funding liquidity risk as defined in Basel III have an economically meaningful bidirectional relationship. However, the effect on CDS spread is ambiguous. While capital appears to have a relatively large impact on CDS spread changes, liquidity risk is priced only when it falls below the regulatory threshold.     

Price discovery of subordinated credit spreads for Japanese mega-banks: Evidence from bond and credit default swap markets

This paper investigates the determinants and dynamics of subordinated credit spreads for Japanese mega-banks using the bond and credit default swap (CDS) spreads. The main findings are as follows. Subordinated bond and CDS spreads are cointegrated in most cases, and the CDS spread plays a more dominant role in price discovery than the bond spread. In addition, there are significant volatility spillovers from the CDS to bond spread. This information leadership for the CDS spread can largely be explained by stronger reactions of the CDS spread to some financial market variables and bank-specific accounting variables than the bond spread.     

住房贷款违约风险定量分析初探

本首先剖析了影响住房贷款违约风险的主要因素，然后引入Merton的结构化模型来分析住房贷款在等额偿还方式下违约风险的度量问题，并从横向和纵向两个角度，通过模拟计算得出房价波动率和无风险利率对住房贷款的违约概率、预期损失和违约风险溢价的影响规律以及这三个指标在贷款期内的变化规律。     

Pricing Sovereign Credit Risk of Poland: Evidence from the CDS Market

We analyze the market assessment of sovereign credit risk using a reduced-form model to price the credit default swap (CDS) spreads, thus enabling us to derive values for the probability of default (PD) and loss given default (LGD) from the quotes of sovereign CDS contracts. We compare different specifications of the models allowing for both fixed and time-varying LGD, and we use these values to analyze the sovereign credit risk of Polish debt throughout the period of a global financial crisis. Our results suggest the presence of a low LGD and a relatively high PD during a recent financial crisis.     

An Empirical Investigation of CDS Spreads Using a Regime-Switching Default Risk Model

Default risk in equity returns can be measured by structural models of default. In this article we propose a credit warning signal (CWS) based on the Merton Default Risk (MDR) model and a Regime-Switching Default Risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics, and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using a dataset of U.S. credit default swap (CDS) contracts around the 2007-8 crisis we construct rating-based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in implied default probabilities several months ahead of notable increases in CDS spreads.     

A reduced form model of default spreads with Markov-switching macroeconomic factors

We examine the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion of yield spreads caused by the risk of default in the context of a reduced form model. For this purpose, we extend the Markov-switching risk-free term structure model of Bansal and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields as well as credit default swap premia. The model is calibrated with consumption, inflation, risk-free yields and default data for Aa, A and Baa bonds from the 1987 to 2008 period. We find that our macroeconomic factors are linked with two out of three sharp increases in the spreads during this sample period, indicating that the spread variations can be related to macroeconomic undiversifiable risk.     

Measuring the effect of watch-preceded and direct rating changes: a note on credit markets

This paper analyzes the importance of distinguishing between watch-preceded and direct rating changes for the credit default swap (CDS) market by examining a total of 2991 rating change announcements, 1526 watchlist placement announcements, and 430 rating affirmations following watchlist placements. The results show that watch-preceded downgrades do not lead to significant CDS market reactions, while direct downgrades are associated with a significant increase in CDS spread levels. Likewise, we document that watchlist placements for downgrade lead to increases in firms’ CDS spreads. CDS markets do not react to rating upgrades but watchlist placements for upgrade result in an immediate decrease in CDS spreads. Rating affirmations following watchlist placements for downgrade lead to slight reductions in CDS spreads, while affirmations following watchlist placements for upgrade have no effect on CDS spreads. These findings demonstrate the importance for empirical research on the interaction between credit markets and rating announcements to differentiate between watch-preceded and direct rating changes, particularly for rating downgrades.     

Regime dependent determinants of credit default swap spreads

Credit default swap (CDS) spreads display pronounced regime specific behaviour. A Markov switching model of the determinants of changes in the iTraxx Europe indices demonstrates that they are extremely sensitive to stock volatility during periods of CDS market turbulence. But in ordinary market circumstances CDS spreads are more sensitive to stock returns than they are to stock volatility. Equity hedge ratios are three or four times larger during the turbulent period, which explains why previous research on single-regime models finds stock positions to be ineffective hedges for default swaps. Interest rate movements do not affect the financial sector iTraxx indices and they only have a significant effect on the other indices when the spreads are not excessively volatile. Raising interest rates may decrease the probability of credit spreads entering a volatile period.     

Modeling CDS spreads: A comparison of some hybrid approaches

According to the credit risk model proposed by Cathcart and El-Jahel (2006), default can occur either expectedly, when a certain signaling variable breaches a lower barrier, or unexpectedly, as the first jump of a Poisson process, whose intensity depends on the signaling variable itself and on the interest rate. In the present paper we test the performances of such a model and of other three models generalized by it in fitting the term structure of credit default swap (CDS) spreads. In order to do so, we derive a semi-analytical formula for pricing CDSs and we use it to fit the observed term structures of 65 different CDSs. The analysis reveals that all the model parameters yield a relevant contribution to credit spreads. Moreover, if the dependence of the default intensity on both the signaling variable and the interest rate is removed, the pricing of CDSs becomes very simple, from both the analytical and the computational standpoint, while the goodness-of-fit is reduced by only a few percentage points. Therefore, when using the credit risk model proposed by Cathcart and El-Jahel (2006), assuming a constant default intensity provides an interesting and efficient compromise between parsimony and goodness-of-fit. Furthermore, by fitting the term structure of CDS spreads on a period of about twelve years, we find that the parameters of the model with constant default are rather stable over time, and the goodness-of-fit is maintained high.     

Dynamic credit default swap curves in a network topology

Systemically important banks are connected and their default probabilities have dynamic dependencies. An extraction of default factors from cross-sectional credit default swap (CDS) curves allows us to analyze the shape and the dynamics of default probabilities. In extending the Dynamic Nelson Siegel (DNS) model to an across firm multivariate setting, and employing the generalized variance decomposition of Diebold and Yilmaz [On the network topology of variance decompositions: Measuring the connectedness of financial firms. J. Econom., 2014, 182(1), 119–134], we are able to establish a DNS network topology. Its geometry yields a platform to analyze the interconnectedness of long-, middle- and short-term default factors in a dynamic fashion and to forecast the CDS curves. Our analysis concentrates on 10 financial institutions with CDS curves comprising of a wide range of time-to-maturities. The extracted level factor representing long-term default risk shows a higher level of total connectedness than those derived for short-term and middle-term default risk, respectively. US banks contributed more to the long-term default spillover before 2012, whereas European banks were major default transmitters during and after the European debt crisis, both in the long-term and short-term. The comparison of the network DNS model with alternatives proposed in the literature indicates that our approach yields superior forecast properties of CDS curves.     

Market discipline and too-big-to-fail in the CDS market: Does banks' size reduce market discipline?

This paper examines market discipline in the credit default swap (CDS) market and the potential distortion of CDS spreads which arises when a bank is thought to be too-big-to-fail. Overall, we find evidence for market discipline in the CDS market. However, CDS prices are distorted by a size effect when a bank is considered to be too-big-to-fail. A 1 percentage point increase in size reduces the CDS spread of a bank by about 2 basis points. We further find that some banks have already reached a size that makes them too-big-to-be-rescued. While the price distortion for these banks decreases, the existence of banks that are considered to be too-big-to-rescue raises important new issues for banking supervisors.     

Credit default swaps and the market for sovereign debt

In this paper, we analyze the determinants and effects of credit default swap (CDS) trading initiation in the sovereign bond market. CDS trading initiation is associated with a 30–150 basis point reduction in sovereign bond yields, with greater yield reductions accruing to higher default risk economies. For countries with high default risk, rated B or lower by Standard and Poor’s, CDS initiation is also associated with significant price efficiency benefits in the underlying market. CDS trading initiation is more likely following increases in local equity index volatility, index spreads for regional and global CDS markets, or depreciation of the local currency relative to the US dollar, and decreases in a country’s ability to service foreign debt. Our results are robust to selection bias controls based on these factors.     

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.     

The effect of liquidity and solvency risk on the inclusion of bond covenants

Studies have analyzed the impact of firm and issue characteristics but not liquidity and solvency components of financial distress on the use of bond covenants. Using a comprehensive database of corporate bonds from 2001 to 2012, we find that firm liquidity, measured by standardized Lambda, has a negative statistical and economic impact on the inclusion of all categories and sub-categories of restrictive bond covenants. Developed from financial statement information by Emery and Lyons (1991), Lambda is designed as a coverage ratio that, under certain distribution assumptions, maps into the probability of a firm being unable to pay its short-term bills. The strongest solvency proxy is the 10-year credit default swap (CDS) spread which is significant across the categories and sub-categories for investment and payment covenants, weakly significant for the subordinated debt sub-category of the subsequent financing covenant, but strongly significant for the control poison put sub-category of event covenants. This evidence supports a model that uses SLambda as a proxy for liquidity risk and the 10-year CDS spread as a proxy for solvency risk. The liquidity/covenant relationship is dampened when firms have access to commercial paper funding or bank loans. However, during the recent financial crisis liquidity event this liquidity/covenant relationship was enhanced especially for firms which were dependent on commercial paper during this time when the commercial paper market was deteriorating.