Credit Default Swaps: Risk Hedge or Financial Weapon of Mass Destruction?

Credit default swaps (CDSs) are contracts between buyers and sellers of protection against default. They are a form of debt insurance, or more precisely derivatives contracts that investors buy to either insure against or profit from a default. In this way CDS contracts act as a form of debt insurance in that they provide a means of protection against credit risk. In the aftermath of the global financial crisis, the CDS earned the reputation of a ‘financial weapon of mass destruction’. Why? Is this charge justified? This paper shows that the reality is more complex: CDSs carry benefit as well as costs, and the risks associated with them can be mitigated through prudent supervision.     

Supply chain finance and impacts of consumers’ sustainability awareness

Several new methods have been proposed for supply chain finance (SCF) with bank credits, but none of them mentions how to solve the borrowers’ moral hazard problems in SCF. This paper examines the moral hazard problem in supply chain financing with procurement contract (or purchase order). We show that since supply chain is an up-down directed structure, when financing with the procurement contract, the supplier’s effort monitoring task can be rendered to the procurement contract, which can secure the supplier’s optimal effort and capital choices in production. Hence, compared to separate lending, the supplier’s credit rationing problem can be mitigated, and most importantly, banks’ under-estimation on the supplier’s default risk and the over-estimation on the retailer’s default risk will both decrease. We further show that the retailer’s corporate social responsibility expenditure can increase consumers’ brand recognition, thus when facing demand shocks arising from consumer’s unexpected concerns, the retailer can better stabilize the firm value.     

Securitization and optimal retention under moral hazard

Securitization improves liquidity in capital markets by allowing originators to remove issued loans from its balance sheet and use the proceeds for other purposes. Securitization is often suspected of being one of the main reasons for the recent financial crisis. One concern is that securitization leads to moral hazard in lender screening and monitoring. By selling loans to investors and removing them from their books, banks have a lesser incentive to carefully evaluate and monitor borrowers’ credit quality to ensure that they can repay their loans. One problem in the literature is that the analysis of securitization is very general and suffers from a lack of specific security design analysis under asymmetric information. We address the moral hazard problem using a principal–agent model where the investor is the principal and the lender is the agent. We show that the optimal contract must contain a retention clause in the presence of moral hazard. The optimal retention is affected by tranching and credit enhancement.     

Moral hazard,debt overhang and capital structure

This paper investigates the impact of managerial moral hazard on the debt overhang of a firm by constructing a contingent claims model in which the manager faces costly effort. Using a calibrated capital structure model, we show that the costs of debt overhang become more serious in the presence of managerial moral hazard. Such costs even account for more than half of the total agency costs at a high level of cash flow. Moreover, in contrast to the results of Hackbarth and Mauer (2012), our model predicts a U-shaped relationship between the leverage ratio and investment opportunities of a firm, which is caused by managers’ moral hazard. Finally, by considering this moral hazard, we also show the coexistence of low leverage ratios and high credit spreads, which explains the phenomenon of “low debt levels and high credit spreads” observed in practice.     

Spillovers among CDS indexes in the US financial sector

By employing the robust cross-correlation function approach proposed by Hong (2001), and conducting pre-tests for structural breaks in the variances as well as removing the causality-in-mean effects in the causality-in-variance tests, we investigate volatility and mean transmissions between the credit default swaps (CDS) indexes of three US financial sectors. We use daily series on five-year banking, insurance, and financial services sector CDS indexes at the sector level from January 2004 to December 2011. We find evidence of significant causality-in-mean effects running from the banking sector to the insurance and financial services sector CDS indexes and from the financial services to the insurance sector CDS indexes, suggesting the leading role of the banking and financial services sectors in terms of price discovery. Moreover, we find significant causality-in-variance effects from the financial services sector CDS index to that of the banking sector, implying the existence of information transmission and contagion from the former, the least regulated of the three. The implications of these findings on traders and policymakers are also provided.     

After Modigliani,Miller, and Hamada: A new way to estimate cost of capital

In this article, we discuss the impact of financial debt on shareholder value using a new approach that aims: (a) to explain the effect that leverage from debt has on a stock’s systematic risk, or what we shall call here “the systematic cost of leverage,” and (b) to account for default risk in the cost of equity, or what we shall call here “the cost of default.” Our assessment of systematic risk is based on a stochastic approach that is materially different from the one proposed by Hamada: the risk premium remunerates the investor for the probability of equity (expressed as market value) generating a return below that of the risk‐free rate. Furthermore, the approach we use to account for default risk is derived from reduced‐form models, but in this case, (a) we use real probabilities of default and not risk‐neutral probabilities, and (b) we extend the approach to stocks.     

Market perception of sovereign credit risk in the euro area during the financial crisis

We study market perception of sovereign credit risk in the euro area during the financial crisis. In our analysis we use a parsimonious CDS pricing model to estimate the probability of default (PD) and the loss given default (LGD) as perceived by financial markets. In our empirical results the estimated LGDs perceived by financial markets stay comfortably below 40% in most of the samples. Global financial indicators are positively and strongly correlated with the market perception of sovereign credit risk; whilst macroeconomic and institutional developments were at best only weakly correlated with the market perception of sovereign credit risk.     

Measuring connectedness of euro area sovereign risk

We introduce a method for measuring the default risk connectedness of euro zone sovereign states using credit default swap (CDS) and bond data. The connectedness measure is based on an out-of-sample variance decomposition of model forecast errors. Due to its predictive nature, it can respond to crisis occurrences more quickly than common in-sample techniques. We determine the sovereign default risk connectedness using both CDS and bond data in order to obtain a more comprehensive picture of the system. We find evidence that there are several observable factors that drive the difference between CDS and bonds, but both data sources still contain specific information for connectedness spill-overs. In general, we can identify countries that impose risk on the system and the respective spill-over channels. Our empirical analysis covers the years 2009–2014, such that the recovery paths of countries exiting EU and IMF financial assistance schemes and the responses to the ECB’s unconventional policy measures can be analyzed.     

信息不对称下保险信用缺失分析及防范

当前，保险信用缺失已成为制约保险市场进一步发展的瓶颈。文中从投保人、保险人的逆向选择及道德风险三个方面阐述了保险信用缺失的原因，同时提出了健全我国保险信用体系的对策。     

An analysis of default risk in the Home Equity Conversion Mortgage (HECM) program

While reverse mortgages are intended as a tool to enable financial security for older homeowners, in 2014, nearly 12 percent of reverse mortgage borrowers in the federally insured Home Equity Conversion Mortgage (HECM) program were in default on their property taxes or homeowners insurance. Unlike the traditional mortgage market, there were no risk-based underwriting guidelines for HECMs through 2014. In response to the relatively high default rate, a variety of policy responses were implemented, including establishing underwriting guidelines. However, there is a lack of data and analysis to inform such criteria. Our analysis follows 30,000 seniors counseled for reverse mortgages between 2006 and 2011. The data includes comprehensive financial and credit report attributes, not typically available in analyses of reverse mortgage borrowers. Using a bivariate probit model that accounts for selection, we estimate the likelihood of tax and insurance default. Financial characteristics that increase default risk include the percentage of funds withdrawn in the first month of the loan, a lower credit score, higher property tax to income ratio, low or no unused revolving credit, and a history of being past due on mortgage payments or having a tax lien on the property. Our estimate of the elasticity of default with respect to credit scores is similar to that for closed-end home equity loans, but higher than that for HELOCs. We simulate the effects of alternative underwriting criteria and policy changes on the probability of take-up and default. Reductions in the default rate with a minimal effect on participation can be achieved by requiring that participants with low credit scores set aside some of their HECM funds for future property tax and insurance payments, a form of escrowing.     

Mutual excitation in Eurozone sovereign CDS

We study self- and cross-excitation of shocks in the Eurozone sovereign CDS market. We adopt a multivariate setting with credit default intensities driven by mutually exciting jump processes, to capture the salient features observed in the data, in particular, the clustering of high default probabilities both in time (over days) and in space (across countries). The feedback between jump events and the intensity of these jumps is the key element of the model. We derive closed-form formulae for CDS prices, and estimate the model by matching theoretical prices to their empirical counterparts. We find evidence of self-excitation and asymmetric cross-excitation. Using impulse-response analysis, we assess the impact of shocks and a potential policy intervention not just on a single country under scrutiny but also, through the effect on cross-excitation risk which generates systemic sovereign risk, on other interconnected countries.     

CREDIT DEFAULT SWAPS: HAS THE GFC INFLUENCED PERCEPTIONS OF THEIR UTILITY FOR BANKS?

Credit Default Swaps (CDSs) are considered as one of the most versatile financial innovations of the 21^st century. Since its inception, the credit derivatives market has grown to a peak of $64 trillion in 2008 in terms of gross notional values (Cont, 2010 ). However, after the onset of the GFC, this market has decreased to a large extent. While there is evidence that promotes the risk reduction properties of CDSs, there is a growing body of research post GFC that identifies destabilising effects of these instruments. In this paper, I review the relevant scholarly literature and provide evidence of how the views on CDSs have changed post GFC due a deeper investigation of issues such as systemic risk, regulatory arbitrage, information asymmetry and risk‐taking, among others, in the banking industry. This paper provides a survey of the literature of views ‘for’ and ‘against’ the use of CDSs during pre and post GFC periods and finally concludes that in comparison to the pre GFC period, post GFC there is a significant increase in the literature that highlights the detrimental nature of CDSs.     

Euro‐insurance‐bonds: a long‐term solution for the European sovereign debt problem?

This article proposes that all new Euro area sovereign borrowing be in the form of jointly underwritten ‘Euro‐insurance‐bonds’ trading at the same price for outside investors. To avoid classic moral hazard problems and to insure the guarantors against default, each country would pay a risk premium conditional on economic fundamentals to a joint debt management agency…     

On discrimination in the optimal management of teams

We study the optimal management of teams in which agents’ effort decisions are mapped (via a production technology) into the probability of the team’s success. Optimal wage schemes in such context are largely discriminatory, but we show that the extent of the discrimination crucially depends on the existence of moral hazard. More precisely, for teams with a flat structure, the domain of production technologies giving rise to discrimination is broader when agents’ actions are observable and contractible. For teams with a sequential structure, the result reverses and the domain of production technologies giving rise to discrimination is broader when there exists moral hazard. Finally, in more cooperative environments in which agents are allowed to collude, optimality does not entail discrimination, with or without moral hazard.     

Asset allocation with contagion and explicit bankruptcy procedures

In this paper, we consider the asset allocation problem of an investor allocating his funds between several corporate bonds and a money market account. In particular, we provide a realistic model of financial distress: firstly, we model Chapter 7 and Chapter 11 bankruptcies as different possible outcomes of financial distress. Secondly, we take into consideration that, in practice, “default” is not the end, but the beginning of financial distress, eventually leading to a reorganization or a liquidation of a distressed firm. Thirdly and most importantly, we are able to analyze the impact of contagion on an investor’s demand for corporate bonds. Contagion is an important phenomenon, as it reduces the investor’s ability to diversify his portfolio, and we show that the bond demand can change by more than 50%.     

Sequential optimization three-way decision model with information gain for credit default risk evaluation

To categorize credit applications into defaulters or non-defaulters, most credit evaluation models have employed binary classification methods based on default probabilities. However, while some loan applications can be directly accepted or rejected, there are others on which immediate accurate credit status decisions cannot be made using existing information. To resolve these issues, this study developed an optimized sequential three-way decision model. First, an information gain objective function was built for the three-way decision, after which a genetic algorithm (GA) was applied to determine the optimal decision thresholds. Then, appropriate accept or reject decisions for some applicants were made using basic credit information, with the remaining applicants, whose credit status was difficult to determine, being divided into a boundary region (BND). Supplementary information was then added to reevaluate the credit applicants in the BND, and a sequential optimization process was employed to ensure more accurate predictions. Therefore, the model’s predictive abilities were improved and the information acquisition costs controlled. The empirical results demonstrated that the proposed model was able to outperform other benchmarking credit models based on performance indicators.     

Quality investment timing by the startup and the established firm

This study investigates quality investment timing decisions of the established firm and the startup by a duopoly model, where firms can position quality early (demand uncertainty is high) or late (uncertainty has been resolved), possibly at different costs. The startup positions quality to maximize its survival probability, whereas the established firm maximizes profits. Results indicate that the startup positions quality earlier than the established firm when the demand uncertainty is high and costs do not decline sharply over time. Additionally, policy analysis shows that subsidies work better than direct funds in encouraging quality innovation of the startup.     

创业投资契约机制与机会主义行为

文章从"经济人"的自利性、公平理论和信息不对称等方面分析创业投资活动中道德风险产生的理论原因,并根据投资方和创业方对创业投资契约条款的认知不同,对创业投资契约条款进行分类分析,找出双方的主要分歧,分析创业投资道德风险产生的现实原因。根据道德风险产生的原因,提出建立契约设置的动态调整机制,合理分配投资方和创业方的收益,减少投资方与创业方委托代理关系中的道德风险。这种动态调整机制包括企业价值动态分配机制、信息共享机制、支配权的相机调整机制、双向激励机制和风险分担机制。     

Optimal financial contracts with hidden effort,unobservable profits and endogenous costs of effort

This paper studies financial contracting in a two-period financing model with double moral hazard, as entrepreneurial effort choices and profits are unobservable and non-verifiable. The optimal financial contract must induce both the high effort level and truthful revelation of profits. The paper further analyses the structure of the optimal contract where the entrepreneur's payoff takes a general functional form that allows for endogenously determined costs of effort. The entrepreneur's performance is influenced by not only extrinsic work motivation factors but also intrinsic factors so that the degree of control imposed by the investor, in the form of end-of-period transfers, affects the entrepreneur's costs of effort. The finding shows that under well-defined conditions, the optimal contract that solves a model with non-verifiable profits also elicits effort, and generally resembles a simple debt contract. The structure of the optimal contract is robust in the general case where the entrepreneur's payoff function is non-linear in transfers.     

Asymmetric convergence in US financial credit default swap sector index markets

This study examines the asymmetric adjustments to the long-run equilibrium for credit default swap (CDS) sector indexes of three financial sectors – banking, financial services and insurance – in the presence of a threshold effect. The results of the momentum-threshold autoregression (M-TAR) models demonstrate that asymmetric cointegration exists for all pairs comprised of those three CDS indexes. The speeds of adjustment in the long-run are much higher in the case of adjustments from below the threshold than from above for all the pairs. The estimates of The MTAR-VEC models suggest that the dual CDS index return in each sector pair participates in the adjustment to equilibrium in the short- and long-run taken together. But in the long-run alone, only one of the two spreads in each pair participates. Policy implications are also provided.