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.     

The information content of option-implied volatility for credit default swap valuation

Credit default swaps (CDS) are similar to out-of-the-money put options in that both offer a low cost and effective protection against downside risk. This study investigates whether put option-implied volatility is an important determinant of CDS spreads. Using a large sample of firms with both CDS and options data, we find that individual firms’ put option-implied volatility dominates historical volatility in explaining the time-series variation in CDS spreads. To understand this result, we show that implied volatility is a more efficient forecast for future realized volatility than historical volatility. More importantly, the volatility risk premium embedded in option prices covaries with the CDS spread. These findings complement existing empirical evidence based on market-level data.     

Counterparty credit risk and the credit default swap market

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers' credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.     

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.     

Tempered stable structural model in pricing credit spread and credit default swap

In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Lévy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.     

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.     

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.     

The delivery option in credit default swaps

Under standard assumptions the reduced-form credit risk model is not capable of accurately pricing the two fundamental credit risk instruments – bonds and credit default swaps (CDS) – simultaneously. Using a data set of euro-denominated corporate bonds and CDS our paper quantifies this mispricing by calibrating such a model to bond data, and subsequently using it to price CDS, resulting in model CDS spreads up to 50% lower on average than observed in the market. An extended model is presented which includes the delivery option implicit in CDS contracts emerging since a basket of bonds is deliverable in default. By using a constant recovery rate standard models assume equal recoveries for all bonds and hence zero value for the delivery option. Contradicting this common assumption, case studies of Chapter 11 filings presented in the paper show that corporate bonds do not necessarily trade at equal levels following default. Our extension models the implied expected recovery rate of the cheapest-to-deliver bond and, applied to data, largely eliminates the mispricing. Calibrated recovery values lie between 8% and 47% for different obligors, exhibiting strong variation among rating classes and industries. A cross-sectional analysis reveals that the implied recovery parameter depends on proxies for the delivery option, primarily the number of available bonds and bond pricing errors. No evidence is found for a direct influence of the bid-ask spread, notional amount, coupon, or rating used as proxies for bond market liquidity.     

Tournament incentives and firm credit risk: Evidence from credit default swap referenced firms

In this paper, we evaluate the impact of managerial tournament incentives on firm credit risk in credit default swap (CDS) referenced firms. We find that intra‐firm tournament incentives are negatively related to credit risk. Our results suggest that tournament incentives reduce credit risk by alleviating the potential for underinvestment when managers are concerned about exacting empty creditors. Further, we find that tournament incentives decrease credit risk when internal governance is strong or product market competition is intense. Taken together, our results suggest that creditors perceive senior manager tournament incentives (SMTI) as a critical determinant of a firm's credit risk, particularly in settings where managerial risk aversion is high.     

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 reaction of emerging market credit default swap spreads to sovereign credit rating changes

This paper examines the effect of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies’ CDS premiums. We find that positive events have a greater impact on CDS markets in the two-day period surrounding the event, and are more likely to spill over to other emerging countries. Alternatively, CDS markets anticipate negative events, and previous changes in CDS premiums can be used to estimate the probability of a negative credit event. The transmission mechanisms for positive events are the common creditor and competition in trade markets.     

Hedging emerging market bonds and the rise of the credit default swap

On October 5, 2001, when credit spreads were widening, the Chicago Mercantile Exchange CME de-listed the full menu of emerging market Brady bond futures contracts. This is intriguing because at a time when interest in hedging and speculating in emerging market sovereign credit risk should be at its peak, the CME de-listed precisely the sort of contract designed to hedge and speculate in sovereign credit risk. This paper finds statistical evidence suggesting that the developing over the counter CDS contract acted as a substitute product for the Brady bond futures contract thereby undermining the Brady bond futures contract and contributing to its demise.     

Pricing of credit default index swap tranches with one-factor heavy-tailed copula models

In this paper, we provide two one-factor heavy-tailed copula models for pricing a collateralized debt obligation and credit default index swap tranches: (1) a one-factor double t distribution with fractional degrees of freedom copula model and (2) a one-factor double mixture distribution of t and Gaussian distribution copula model. A time-varying tail-fatness parameter is introduced in each model, allowing one to change the tail-fatness of the copula function continuously. Fitting our model to comprehensive market data, we find that a model with fixed tail-fatness cannot fit market data well over time. The two models that we propose are capable of fitting market data well over time when using a proper time-varying tail-fatness parameter. Moreover, we find that the time-varying tail-fatness parameters change dramatically over a one-year period.     

Investigating the dependence structure between credit default swap spreads and the U.S. financial market

Under Basel II framework, credit risk assessment is of high significance in the light of correlation risk. Correlation risk is often envisioned along with business conditions and financial market’s impact. We employ copula methodology to identify the dependence structures that may exist between market risk fundamentals and credit risk fundamentals. Considering credit derivative spreads as credit risk fundamentals and market data as market risk determinants, we describe and quantify the asymmetric link prevailing between credit risk and market risk. Credit risk is negatively linked with market price risk whereas it becomes positively linked with market volatility risk. Such patterns give rise to interesting asymmetric dependence structures between both risk sources. We are then able to balance reliably market price risk with market volatility feedback, the market trend supporting a common correlation between securities. In the light of the previous trade-off, we propose also a simple credit risk management rule.     

Network structures and idiosyncratic contagion in the European sovereign credit default swap market

This study combines conditional Granger causality and network analysis to examine the interconnectedness in the European sovereign credit default swap (CDS) market. We determine that the network is unstable in the short term and stable in the long term. Further, we visualize dynamic networks and confirm financial contagion in the 2012 European debt crisis. The sources of risk spillovers and the manner in which spillovers are transferred among countries are identified accordingly. Further, we conclude that interconnectedness can be a pricing factor for determining the sovereign CDS return. The results of the network analysis indicate that the European sovereign CDS market is a complex network system and can serve as a valuable reference for investors and policymakers.     

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.     

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.     

The effect of corporate diversification on credit risk: new evidence from European credit default swap spreads

This article investigates the impact of corporate diversification on credit risk. To our best knowledge, this is the first paper to use credit default swap (CDS) spreads instead of bond yield or revalued book values to test the risk‐reduction hypothesis. The analysis relies upon a sample of STOXX^® EUROPE 600 index members and covers the years 2010–2014. After controlling for various CDS‐ and firm‐specific variables, we find that diversification strategies do not significantly lower CDS premiums. Multilevel mediation analysis further shows that information asymmetries overcompensate the risk‐reducing effects resulting from corporate diversification.     

The leverage effect puzzle: the case of European sovereign credit default swap market

One of the stylized facts about the behaviour of time series is that their volatility exhibits asymmetrical responses to good and bad news. In the case of stock markets, volatility seems to rise when the stock price decreases and fall when the stock price increases. This so-called “leverage effect” was first described by Black (Proceedings of the 1976 meeting of the business and economic statistics section, pp 177–181, 1976). The concept is not new and has already been comprehensively studied and implemented in many volatility models (GARCH and SV) in the form of an additional parameter in the volatility equation. However, there is no study or a theoretical explanation of the leverage effect in sovereign credit default swap spreads (hereinafter: sCDS). In this article, we discuss the possible behaviour of sCDS volatility and explain it by way of reference to the Prospect Theory by Kahneman and Tversky (Econometrica 47(2):263–292, 1979). We estimate a series of stochastic volatility models with the leverage effect, proposed by Yu (J Econom 127(2):165–178, 2005). In this model, the “leverage effect” is, in fact, the same as a coefficient of the correlation between the current return of an asset and its expected future volatility. We show that the effect does exist and differs across markets. As far as the safe European markets are concerned, the parameter is negative; in the case of extremely risky economies—it is positive. In markets of medium risk the effect varies depending on the relationship between the perceived risk and the value of the sCDS premium.