Cross-hedging strategies between CDS spreads and option volatility during crises

This paper presents a joint analysis of the term structure of credit default swap (CDS) spreads and the implied volatility surface for five European countries from 2007 to 2012, a sample period covering both the Global Financial Crisis (GFC) and the European debt crisis. We analyze to which extent effective cross-hedges can be performed between the credit and equity derivatives markets during these two crises. We find that during a global crisis a breakdown of the relationship between credit risk and equity volatility may occur, jeopardizing any cross-hedging strategy, which happened during the GFC. This stands in sharp contrast to the more localized European debt crisis, during which this fundamental relationship was preserved despite turbulent market conditions for both the CDS and volatility markets.     

The role of managerial risk‐taking in the ‘rise and fall’ of the CDS market

Since the innovation of credit default swaps (CDSs) in 1997, the market for CDSs grew dramatically to $62 trillion in 2007 (ISDA 2010). However, this market declined significantly with the onset of the GFC, prompting the question, ‘What lies behind the phenomenal growth and the eventual collapse of the CDS market?’ Using CDS spread data from 319 bank and non‐bank financial institutions across 33 countries over the period 2001–2010, I provide evidence of the determinants that affect risk‐taking by financial institutions, proxied by CDS spreads, and argue within an agency theoretical framework that managerial risk‐taking contributed to the ‘rise and fall’ of the CDS market.     

Daily pricing of emerging market sovereign CDS before and during the global financial crisis

In this paper, we study the determinants of daily spreads for emerging market sovereign credit default swaps (CDSs) over the period April 2002–December 2011. Using GARCH models, we find, first, that daily CDS spreads for emerging market sovereigns are more related to global and regional risk premia than to country-specific risk factors. This result is particularly evident during the second subsample (August 2007–December 2011), where neither macroeconomic variables nor country ratings significantly explain CDS spread changes. Second, measures of US bond, equity, and CDX High Yield returns, as well as emerging market credit returns, are the most dominant drivers of CDS spread changes. Finally, our analysis suggests that CDS spreads are more strongly influenced by international spillover effects during periods of market stress than during normal times.     

Market conditions,default risk and credit spreads

This study empirically examines the impact of the interaction between market and default risk on corporate credit spreads. Using credit default swap (CDS) spreads, we find that average credit spreads decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta, with the effect of cash flow beta varying with market conditions. We identify implied volatility as the most significant determinant of default risk among firm-level characteristics. Overall, a major portion of individual credit spreads is accounted for by firm-level determinants of default risk, while macroeconomic variables are directly responsible for a lesser portion.     

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 determinants of stock–bond return correlations

I study the options-implied market risks that affect US stock–bond correlations from 2007 to 2021. I discover that US stock and bond market uncertainty, stock market tail risk, and global credit-default risk are dominant contributors to changing stock–bond correlations during the global financial crisis (GFC) period. However, these market risks collectively contribute much less to time-varying correlations in the post-GFC period. Furthermore, stock–bond correlations rise in times of rising US and global bond market risks. Rising stock market uncertainty raises stock–bond correlations in the GFC period but lowers them in the post-GFC period. My results disentangle the risks of stock and bond markets and show that equity tail risk, bond market risk, and stock market uncertainty are dominant factors in changing stock–bond diversification benefits in periods of market turmoil.     

Are credit default swaps still a sideshow? How information flow between equity and CDS markets has changed since the financial crisis

We examine the information flow between equity and credit default swap (CDS) markets using firm-level returns data before and after the global financial crisis. Before the crisis, the information flow was unidirectional, with equity returns leading CDS returns. While equity returns continue to lead CDS returns after the crisis, we find that the speed of adjustment of the CDS market to equity markets has increased during this period. We also find evidence of a bidirectional flow of information between these markets, with equity returns responding to credit protection returns in the postcrisis period. The quicker response of CDS spreads to equity returns during the postcrisis period primarily occurs among entities with lower credit ratings. In contrast, the response of equity returns to lagged CDS returns during the postcrisis period is observed among firms across different credit rating categories; however, the magnitude of the response is higher among those with lower credit ratings.     

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.     

Credit spread interdependencies of European states and banks during the financial crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, the Netherlands, Portugal, and Spain) and their domestic banks during the period between June 2007 and May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects sovereign CDS spreads more strongly in the short run. However, the impact becomes insignificant in the long term. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.     

Leverage Choice and Credit Spreads when Managers Risk Shift

We model the debt and asset risk choice of a manager with performance‐insensitive pay (cash) and performance‐sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex‐post asset substitution and that credit spreads are increasing in the ratio of cash‐to‐stock. Using a large cross‐section of U.S.‐based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash‐to‐stock and CDS rates, and between cash‐to‐stock and leverage ratios.     

Price discovery of credit spreads in tranquil and crisis periods

In this paper we investigate the price discovery process in single-name credit spreads obtained from bond, credit default swap (CDS), equity and equity option prices. We analyse short term price discovery by modelling daily changes in credit spreads in the four markets with a vector autoregressive model (VAR). We also look at price discovery in the long run with a vector error correction model (VECM). We find that in the short term the option market clearly leads the other markets in the sub-prime crisis (2007–2009). During the less severe sovereign debt crisis (2009–2012) and the pre-crisis period, options are still important but CDSs become more prominent. In the long run, deviations from the equilibrium relationship with the option market still lead to adjustments in the credit spreads observed or implied from other markets. However, options no longer dominate price discovery in any of the periods considered. Our findings have implications for traders, credit risk managers and financial regulators.     

Hedging credit: Equity liquidity matters

We theorize and confirm a new channel by means of which liquidity costs are embedded in CDS spreads. We show that credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton [Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. J. Finance 29, 449–470] model via hedging. We confirm this relationship empirically using a sample of 1452 quarterly CDS spreads over 2001–2005. In the model, this relationship is monotone increasing when credit quality worsens. These results are robust to alternative measures of equity liquidity and other possible determinants of CDS spreads.     

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.     

Understanding the term structure of credit default swap spreads

The shape of the term structure of credit default swap (CDS) spreads displays large variations over time and across firms. Consistent with the predictions of structural models of credit risk, we find that the slope of CDS spread term structure increases with firm leverage and volatility, but decreases with the level and the slope of the Treasury yield curve. However, these variables together have rather limited explanatory power for CDS slope and there is a significant common component in the regression residuals. In addition, we find that CDS slope predicts future changes in the CDS spreads, even after controlling for the contemporaneous variables that determine changes in the CDS spreads according to the structural models. Our results suggest that while structural models are qualitatively useful for understanding the shape of credit term structure, there are missing factors that importantly affect the term structure of CDS spreads.     

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.     

Has the CDS market lowered the cost of corporate debt?

Many have claimed that credit default swaps (CDSs) have lowered the cost of debt financing to firms by creating new hedging opportunities and information for investors. This paper evaluates the impact that the onset of CDS trading has on the spreads that underlying firms pay to raise funding in the corporate bond and syndicated loan markets. Employing a range of methodologies, we fail to find evidence that the onset of CDS trading lowers the cost of debt financing for the average borrower. Further, we uncover economically significant adverse effects on risky and informationally opaque firms.     

The non-monotonic impact of bank size on their default swap spreads: Cross-country evidence

This paper studies the drivers of bank's credit default swap (CDS) spread, taken as a measure of credit risk, by considering the impact of housing market along with a number of bank level determinants, such as regulatory capital, leverage, size, liquidity, asset quality and operations income ratio. We build upon a unique dataset consisting of 115 banks (during pre- and post-crisis periods) headquartered in 30 countries from both developed and emerging countries. Results suggest that CDS spread is driven by asset quality, liquidity and operations income ratio, while bank size is found to have a non-monotonic impact on CDS spread. If the bank is small, an increase in size reduces the average credit risk. If the bank is large enough, an increase in size raises the latter. From our results we derive the level of bank size that minimizes the CDS spreads. Financial institutions growing beyond this threshold are subject to higher credit risk, implying that smaller and medium sized banks are safer than large banks. When considering the estimates in the periods before and after the 2007 crisis, we further find a different extreme point of bank size in the former (approximately 1642 billion Euros) relative to a significantly lower level of optimal bank size (around 70 billion) in the post-crisis period, implying too-big-to-fail and too-big-to-save in the pre-crisis regime.     

Surprises,sentiments, and the expectations hypothesis of the term structure of interest rates

Between 2005 and 2009, we document evident time-varying credit risk price discovery between the equity and credit default swap (CDS) markets for 174 US non-financial investment-grade firms. We test the economic significance of a simple portfolio strategy that utilizes fluctuation in CDS spreads as a trading signal to set stock positions, conditional on the CDS price discovery status of the reference entities. We show that a conditional portfolio strategy which updates the list of CDS-influenced firms over time, yields a substantively larger realized return net of transaction cost over the unconditional strategy. Furthermore, the conditional strategy’s Sharpe ratio outperforms a series of benchmark portfolios over the same trading period, including buy-and-hold, momentum and dividend yield strategies.     

Understanding the market reaction to shockwaves: Evidence from the failure of Lehman Brothers

The spectacular failure of the 150-year-old investment bank Lehman Brothers on September 15th, 2008 was a major turning point in the global financial crisis that broke out in the summer of 2007. Through the use of stock market data and credit default swap (CDS) spreads, this paper examines investors’ reaction to Lehman's collapse in an attempt to identify a spillover effect on the surviving financial institutions. The empirical analysis indicates that (i) the collateral damage was limited to the largest financial firms; (ii) the institutions most affected were the surviving “non-bank” financial services firms; and (iii) the negative effect was correlated with the financial conditions of the surviving institutions. We also detect significant abnormal jumps in CDS spreads that we interpret as evidence of sudden upward revisions in the market assessment of future default probabilities assigned to the surviving financial firms.     

The impact of central clearing on counterparty risk,liquidity, and trading: Evidence from the credit default swap market

This paper examines the impact of central clearing on the credit default swap (CDS) market using a sample of voluntarily cleared single-name contracts. Consistent with central clearing reducing counterparty risk, CDS spreads increase around the commencement of central clearing and are lower than settlement spreads published by the central clearinghouse. Furthermore, the relation between CDS spreads and dealer credit risk weakens after central clearing begins, suggesting a lowering of systemic risk. These findings are robust to controls for frictions in both CDS and bond markets. Finally, matched sample analysis reveals that the increased post-trade transparency following central clearing is associated with an improvement in liquidity and trading activity.