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.     

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.     

Laying off credit risk: Loan sales versus credit default swaps

How do markets for debt cash flow rights, with and without accompanying control rights, affect the efficiency of lending? A bank makes a loan, learns if it needs monitoring, and then decides whether to lay off credit risk. The bank can transfer credit risk by either selling the loan or buying a credit default swap (CDS). With a CDS, the originating bank retains the loan's control rights; with loan sales, control rights pass to the loan buyer. Credit risk transfer leads to excessive monitoring of riskier credits and insufficient monitoring of safer credits. Increases in banks' cost of equity capital exacerbate these effects. For riskier credits, loan sales typically dominate CDS but not for safer credits. Once repeated lending and consequent reputation concerns are modeled, although CDSs remain dominated by loan sales for riskier credits, for safer credits they can dominate loan sales, supporting better monitoring (albeit to a limited extent) while allowing efficient risk sharing. Restrictions on the bank's ability to sell the loan expand the range in which CDSs are used and monitoring is too low.     

Pricing default swaps: Empirical evidence

In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model outperforms directly comparing bonds' credit spreads to default swap premiums. We find that the model yields unbiased premium estimates for default swaps on investment grade issuers, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is relatively insensitive to the value of the assumed recovery rate.     

The sensitivity of the credit default swap market to financial analysts’ forecast revisions

We examine the impact of analysts’ earnings per share (EPS) and cash flow per share (CPS) forecast revisions on the market for credit default swaps. We find that while the issuance of both EPS and CPS forecast revisions are inversely associated with changes in credit default swap (CDS) spreads, cash flow forecast revisions have a larger effect. We demonstrate that the relationship between CPS forecast revisions and CDS spreads tends to be stronger in cases of financial distress. We provide evidence that cash flow forecasts dominate earnings forecasts in some situations and that participants in the CDS market discriminate between analysts' forecast revisions and recommendation changes.     

Exploring the components of credit risk in credit default swaps

In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.     

Modelling bonds and credit default swaps using a structural model with contagion

This paper develops a two-dimensional structural framework for valuing credit default swaps and corporate bonds in the presence of default contagion. Modelling the values of related firms as correlated geometric Brownian motions with exponential default barriers, analytical formulae are obtained for both credit default swap spreads and corporate bond yields. The credit dependence structure is influenced by both a longer-term correlation structure as well as by the possibility of default contagion. In this way, the model is able to generate a diverse range of shapes for the term structure of credit spreads using realistic values for input parameters.     

Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads

In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specific to the sovereign credit default swap (CDS) and bond markets. We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre- and crisis periods. Secondly, our results indicate that the time-varying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution effect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk is substantially different, there is a strong liquidity flow between the CDS and the bond markets, however, no market seems to consistently lead the other.     

The Information Content of Ratings: An Analysis of Australian Credit Default Swap Spreads

We examine the information content of Australian credit rating announcements by measuring the abnormal changes in credit default swap (CDS) spreads. CDS spreads provide a direct view of credit quality and thus should impound information quickly when investors receive new credit risk related information via a rating event. Using an event study methodology, we show that watch downs and rating upgrades contain valuable information even after controlling for sources of contamination. We find that watch downs elicit statistically significant market reactions, while subsequent downgrades are anticipated. Upgrades are associated with a significant but small abnormal reduction in CDS spreads, whereas watch ups appear to contain no new information.     

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 relationship between liquidity risk and credit risk in banks

This paper investigates the relationship between the two major sources of bank default risk: liquidity risk and credit risk. We use a sample of virtually all US commercial banks during the period 1998–2010 to analyze the relationship between these two risk sources on the bank institutional-level and how this relationship influences banks’ probabilities of default (PD). Our results show that both risk categories do not have an economically meaningful reciprocal contemporaneous or time-lagged relationship. However, they do influence banks’ probability of default. This effect is twofold: whereas both risks separately increase the PD, the influence of their interaction depends on the overall level of bank risk and can either aggravate or mitigate default risk. These results provide new insights into the understanding of bank risk and serve as an underpinning for recent regulatory efforts aimed at strengthening banks (joint) risk management of liquidity and credit risks.     

Single and joint default in a structural model with purely discontinuous asset prices

Structural models of credit risk are known to present both vanishing spreads at very short maturities and a poor spread fit over longer maturities. The former shortcoming, which is due to the diffusive behaviour assumed for asset values, can be circumvented by considering discontinuous asset prices. In this paper the authors resort to a pure jump process of the Variance-Gamma type. First the authors calibrate the corresponding Merton type structural model to single-name data for the DJ CDX.NA.IG and CDX.NA.HY components. By so doing, they show that it also circumvents the diffusive structural models difficulties over longer horizons. Particularly, it corrects for the underprediction of low-risk spreads and the overprediction of high-risk ones. Then the authors extend the model to joint default, resorting to a recent formulation of the VG multivariate model and without superimposing a copula choice. They fit default correlation for a sample of CDX.NA names, using equity correlation. The main advantage of our joint model, with respect to the existing non-diffusive ones, is that it allows full calibration without the equicorrelation assumption, but still in a parsimonious way. As an example of the default assessments which the calibrated model can provide, the authors price an FtD swap.     

The use of credit default swaps by bond mutual funds: Liquidity provision and counterparty risk

Corporate bond mutual funds increased their selling of credit protection in the credit default swaps (CDS) market during the 2007–2008 financial crisis. This trading activity was primarily in multi-name CDS, greater among larger and established funds, and directed toward counterparty dealers in financial distress. Funds that sold credit protection during the crisis experienced greater credit market risk and superior post-crisis performance, consistent with higher expected returns from liquidity provision. Funds using Lehman Brothers as a counterparty experienced abnormal outflows and returns of –2% immediately following Lehman's bankruptcy, suggesting that funds’ opportunistic trading in CDS exposed investors to counterparty risk.     

Effects of market default risk on index option risk-neutral moments

We investigate the relative importance of market default risk in explaining the time variation of the S&P 500 Index option-implied risk-neutral moments. The results demonstrate that market default risk is positively (negatively) related to the index risk-neutral volatility and skewness (kurtosis). These relations are robust in the presence of other factors relevant to the dynamics and microstructure nature of the spot and option markets. Overall, this study sheds light on a set of economic determinants which help to understand the daily evolution of the S&P 500 Index option-implied risk-neutral distributions. Our findings offer explanations of why theoretical predictions of option pricing models are not consistent with what is observed in practice and provide support that market default risk is important to asset pricing.     

Counterparty Risk for Credit Default Swaps: Markov Chain Interacting Intensities Model with Stochastic Intensity

We analyze the counterparty risk for credit default swaps using the Markov chain model of portfolio credit risk of multiple obligors with interacting default intensity processes. The default correlation between the protection seller and underlying entity is modeled by an increment in default intensity upon the occurrence of an external shock event. The arrival of the shock event is a Cox process whose stochastic intensity is assumed to follow an affine diffusion process with jumps. We examine how the correlated default risks between the protection seller and the underlying entity may affect the credit default premium in a credit default swap.     

上市公司违约风险、盈余质量与银行信用借款——基于沪深A股市场的经验研究

本文从静态和动态两个层面研究了会计信息的银行债务契约有用性。实证研究发现,上市公司基于会计信息的违约风险越大,银行信用借款比例越低;盈余质量越差则会显著降低违约风险与信用借款之间的关系;而在区分了长短期信用借款后,上述关系仅存在于短期信用借款之中。进一步研究发现,银企关系的好坏会显著影响长期信用借款的比例。这表明会计信息能降低银行债务契约决策中的信息不对称,但其有用性却受到盈余质量和债务期限的影响。     

Risk management of deposit insurance corporations with risk-based premiums and credit default swaps

In this paper, we propose a risk-based model for deposit insurance premiums and provide the closed-form formula for premiums, including early closure, capital forbearance, interest rate risk, and moral hazard. Our numerical analysis confirms the proposed pricing formula and the relative impact of the provisions for deposit insurance premiums. We illustrate how to use credit default swaps (CDSs) to manage the bank’s asset risk corresponding to the deposit insurance model. A failed bank, Washington Mutual, is used to demonstrate how to calibrate the model’s parameters and calculate fair premiums that are consistent with market risks on the basis of our proposed model and credit derivatives. Finally, a numerical experiment is designed to determine the optimal hedge ratio, which can minimise the variance of cash-flow of the deposit insurance corporations.     

Pricing of swaps with default risk

In this paper, I study the valuation of interest rate and currency swaps with default risk under the contingent claim analysis framework. I demonstrate that the traditional approach of pricing swap contracts as exchanges of loans underestimates the value of such contracts to the counterparty with higher credit rating and exaggerates the credit spread required to guard against default risk. Numerical simulations show that the swap rate is not sensitive to counterparty credit rating: for a ten year interest rate swap, a one hundred basis point increase in counterparty bond yield spread results in only about one basis point increase in the swap rate. (JEL G10, G12, G13)This paper is based on Chapter 2 of my Ph.D. dissertation at Yale University. I would like to thank my dissertation committee, Kenneth French, Roger Ibbotson, and Jonathan Ingersoll, Jr. (chairman), for helpful advice and guidance. I would also like to thank Keny Back, Richard Lindsey, N. R. Prabhala, Ming Huang, Marti Subrahmanyam, three anonymous referees and especially Bob Jarrow, the editor, for helpful comments and suggestions. Any errors that remain are solely mine. This paper won the 1996 Trefftzs Award for best student paper from the Western Finance Association.     

CDS as insurance: Leaky lifeboats in stormy seas

What market features of financial risk transfer exacerbate counterparty risk? To analyze this, we formulate a model which elucidates important differences between financial risk transfer and traditional insurance, using the example of Credit Default Swaps (CDS). We allow for (heterogeneous) insurer insolvency, which captures the possibility that relatively risky counterparties may exist in the market. Further, we find that stable insurers become less stable as the price of the contract decreases. The analysis includes insured parties that have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for trading purposes. We show that traders will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that removes traders can, perversely, cause stable counterparties to become less stable. We conclude with two extensions of the model that consider a Central Counterparty (CCP) arrangement and the consequences of asymmetric information over insurer type.     

The real effects of credit default swaps

We examine the effect of introducing credit default swaps (CDSs) on firm value. Our model allows for dynamic investment and financing, and bondholders can trade in the CDS market. The model incorporates both negative and positive effects of CDSs. CDS markets lead to more liquidations, but they also reduce the probability of costly debt renegotiation and reduce costly equity financing. After calibrating the model, we find that firm value increases by 2.9% on average with the introduction of a CDS market. Firms also invest more and increase leverage. The effect on firm value is strongest for small, financially constrained, and low productivity firms.