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.     

The pricing of accruals quality in credit default swap spreads

We examine the association between accounting information risk, measured with accruals quality (AQ), and credit spreads, primarily measured with credit default swap (CDS) spreads. Theoretically, AQ measures the precision with which accruals map into cash flows. Better AQ implies a more precise estimate of future cash flows and, we predict, a reduction in credit spreads due to resulting lower uncertainty regarding the ability to meet debt interest and principal payments. In support of this hypothesis, we find a negative relationship between AQ and CDS spreads whereby better AQ is associated with lower CDS spreads. Additionally, we investigate the components of total AQ and find that innate AQ is more strongly associated with CDS spreads than is discretionary AQ. We further show that AQ moderates the market's pricing of earnings: the relationship between earnings and CDS spreads weakens as AQ worsens. Together, our results indicate that accounting information risk is priced in credit spreads and that the CDS market responds not only to the level of earnings, but the quality thereof as well.     

The impact of credit rating announcements on credit default swap spreads

We document the ability of the credit default swap (CDS) market to anticipate favorable as well as unfavorable credit rating change (RC) announcements based on more extensive samples of credit rating events and CDS spreads than previous studies. We obtain four new results. In contrast to prior published studies, we find that corporate RC upgrades do have a significant impact on CDS spreads even though they are still not as well anticipated as downgrades. Second, CreditWatch (CW) and Outlook (OL) announcements, after controlling for prior credit rating events, lead to significant CARs at the time positive CW and OL credit rating events are announced. Third, we extend prior results by showing that changes in CDS spreads for non-investment-grade credits contain information useful for estimating the probability of negative credit rating events. Fourth, we find that the CDS spread impact of upgrades but not downgrades is magnified during recessions and that upgrades and downgrades also differ as to the impact of simultaneous CW/OL announcements, investment-grade/speculative-grade crossovers, current credit rating, market volatility, and industry effects.     

Sovereign CDS spread determinants and spill-over effects during financial crisis: A panel VAR approach

This paper examines the determinants of CDS spreads and potential spillover effects for Eurozone countries during the recent financial crisis in the EU. We employ a Panel Vector Autoregressive (PVAR) model which combines the advantages of traditional VAR modelling with those of a panel-data approach. In addition to variables that proxy for global and financial market spread determinants we also employ variables that proxy for behavioral determinants. We find that the determinants of CDS variance are neither uniform nor stable during different periods and different countries. For instance, as we move from 2008 to 2014 the impact of the slope of the term structure on CDS spread variance is increasing for peripheral countries such as Spain, Portugal, Italy, Greece, Ireland, and decreasing for core countries such as Germany, France, Netherlands, Belgium and Austria. Other findings indicate that investor sentiment was an important CDS spread determinant during the subprime crisis, along with other factors, while spillover effects run from larger peripheral economies such as Spain and Italy to core countries; spillover effects from Portugal, Greece, and Ireland are of minor importance.     

Good and bad credit contagion: Evidence from credit default swaps

This study examines the intra-industry information transfer effect of credit events, as captured in the credit default swaps (CDS) and stock markets. Positive correlations across CDS spreads imply that contagion effects dominate, whereas negative correlations indicate competition effects. We find strong evidence of contagion effects for Chapter 11 bankruptcies and competition effects for Chapter 7 bankruptcies. We also introduce a purely unanticipated event, in the form of a large jump in a company's CDS spread, and find that this leads to the strongest evidence of credit contagion across the industry. These results have important implications for the construction of portfolios with credit-sensitive instruments.     

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.     

Regime-Dependent Determinants of China’s Sovereign Credit Default Swap Spread

We study the determinants of China’s sovereign credit default swap (CDS) spread in a regime-switching framework. This framework allows us to identify potential cross-asset-class contagion from global financial markets to China. To avoid endogeneity biases coming from domestic costs of sovereign default, we model domestic financial indicators as endogenous variables and estimate the regime-switching model with instrumental variables. We find strong evidence of cross-asset-class contagion but no evidence of contagion from sovereign CDS markets of China’s major trade partners (the European Union, Japan, and the United States).     

The market impact of systemic risk capital surcharges

This paper tests the ‘Too-Big-to-Fail’ hypothesis that whether being designated as a global systemically important bank (G-SIB) has an impact on the credit default swap (CDS) price of the bank, thereby reducing its credit risk. We find surprising evidence that the CDS spreads of a bank increase (decrease) after the announcement of a higher (lower) capital surcharge. However, this effect is temporary, as the mean CDS spreads revert to preannouncement level, dropping sharply after the initial rise. These findings create a puzzle by implying that a higher capital surcharge requirement and more stringent regulation could outweigh the implicit subsidy advantages of being too-big-to-fail.     

Credit spreads: An empirical analysis on the informational content of stocks,bonds, and CDS

This paper explores the dynamic relationship between stock market implied credit spreads, CDS spreads, and bond spreads. A general VECM representation is proposed for changes in the three credit spread measures which accounts for zero, one, or two independent cointegration equations, depending on the evidence provided by any particular company. Empirical analysis on price discovery, based on a proprietary sample of North American and European firms, and tailored to the specific VECM at hand, indicates that stocks lead CDS and bonds more frequently than the other way round. It likewise confirms the leading role of CDS with respect to bonds.     

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.     

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.     

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.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

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.     

Does the European Financial Stability Facility Bail Out Sovereigns or Banks? An Event Study

On May 9, 2010 euro zone countries announced the creation of the European Financial Stability Facility. This paper investigates the impact of this announcement on bank share prices, bank credit default swap (CDS) spreads, and sovereign CDS spreads. The main private beneficiaries were bank creditors. Furthermore, countries with banking systems heavily exposed to southern Europe and Ireland benefited, as evidenced by lower sovereign CDS spreads. The combined gains of bank debt holders and shareholders exceed the increase in the value of their banks’ sovereign debt exposures, suggesting that banks saw their contingent claim on the financial safety net increase in value.     

THE SLOPE OF THE TERM STRUCTURE OF CREDIT SPREADS: AN EMPIRICAL INVESTIGATION

In this article we analyze the slope of the term structure of credit spreads. We investigate the explanatory role of interest rate, market, and idiosyncratic equity variables that the recent empirical literature highlights as important determinants of credit spread levels. This study extends the analysis and assesses its effect on credit slopes for a sample of corporate bonds. We find that these factors affect credit spreads at short and long maturities in a significantly different way. A closer inspection of the credit spread slope also reveals that it is a useful indicator of the direction of changes in future short‐term credit spreads. This evidence has important implications for the trading and risk management of portfolios of bonds with different maturities.     

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.     

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.     

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.     

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.