An Empirical Investigation of CDS Spreads Using a Regime-Switching Default Risk Model

Default risk in equity returns can be measured by structural models of default. In this article we propose a credit warning signal (CWS) based on the Merton Default Risk (MDR) model and a Regime-Switching Default Risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics, and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using a dataset of U.S. credit default swap (CDS) contracts around the 2007-8 crisis we construct rating-based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in implied default probabilities several months ahead of notable increases in CDS spreads.     

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.     

A first-passage-time model under regime-switching market environment

In this paper, we suggest a first-passage-time model which can explain default probability and default correlation dynamics under stochastic market environment. We add a Markov regime-switching market condition to the first-passage-time model of Zhou [Zhou, C., 2001. An analysis of default correlations and multiple defaults. Review of Financial Studies 14, 555–576]. Using this model, we try to explain various relationship between default probability, default correlation, and market condition. We also suggest a valuation method for credit default swap (CDS) with (or without) counterparty default risk (CDR) and basket default swap under this model.Our numerical results provide us with several meaningful implications. First, default swap spread is higher in economic recession than in economic expansion across default swap maturity. Second, as the difference of asset return volatility between under bear market and under bull market increases, CDS spread increases regardless of maturity. Third, the bigger the intensity shifting from bull market to bear market, the higher the spread for both CDS without CDR and basket default swap.     

Game changer? The impact of the VW emission-cheating scandal on the interrelation between large automakers’ equity and credit markets

This paper investigates the change in the securities market pricing behavior of 16 large, global automakers following disclosure of the Volkswagen (VW) emission-cheating scandal on September 18, 2015, when the EPA issued a notice of violation to VW, stating that VW had intentionally circumvented the US clean air rules for diesel automobile emissions. We contend that this event unblocked an informational cascade, in that much of the information was already known to outside parties, yet no significant market response occurred until the September 18 EPA notice. We also find a significant change in the evolution of equity and credit default swap (CDS) prices in the automobile industry consistent with more-informed trading in the equity market. A test of economic significance further supports this finding by showing a decrease in the profitability of a trading rule based on a predictive relation between CDS spread changes and lagged equity returns.     

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.     

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.     

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.     

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.     

Endogenous liquidity in credit derivatives

We study the determination of liquidity provision in the single-name credit default swap (CDS) market as measured by the number of distinct dealers providing quotes. We find that liquidity is concentrated among large obligors and those near the investment-grade/speculative-grade cutoff. Consistent with endogenous liquidity provision by informed financial institutions, more liquidity is associated with obligors for which there is a greater information flow from the CDS market to the stock market ahead of major credit events. Furthermore, the level of information heterogeneity plays an important role in how liquidity provision responds to transaction demand and how liquidity is priced into the CDS premium.     

Did the Market Signal Impending Problems at Northern Rock? An Analysis of Four Financial Instruments

The academic literature has regularly argued that market discipline can support regulatory authority mechanisms in ensuring banking sector stability. This includes, amongst other things, using forward‐looking market prices to identify those credit institutions that are most at risk of failure. The paper's key aim is to analyse whether market investors signalled potential problems at Northern Rock in advance of the bank announcing that it had negotiated emergency lending facilities at the Bank of England in September 2007. A further aim of the paper is to examine the signalling qualities of four financial market instruments (credit default swap spreads, subordinated debt spreads, implied volatility from options prices and equity measures of bank risk) so as to explore both the relative and individual qualities of each. The paper's findings, therefore, contribute to the market discipline literature on using market data to identify bank risk‐taking and enhancing supervisory monitoring. Our analysis suggests that private market participants did signal impending financial problems at Northern Rock. These findings lend some empirical support to proposals for the supervisory authorities to use market information more extensively to improve the identification of troubled banks. The paper identifies equities as providing the timeliest and clearest signals of bank condition, whilst structural factors appear to hamper the signalling qualities of subordinated debt spreads and credit default swap spreads. The paper also introduces idiosyncratic implied volatility as a potentially useful early warning metric for supervisory authorities to observe.     

Credit default swap prices as risk indicators of listed German banks

This paper explores empirically the usefulness of credit default swap (CDS) prices as market indicators. The sample of reference entities consists of large, internationally active German banks and the observation period covers 3 years. By analysing the explanatory power of three risk sources: idiosyncratic credit risk, systematic credit risk and liquidity risk, we gain important insights into modeling the dynamics of CDS spreads. The impact of systematic risk, for example, has three components; one is related to the overall state of the economy, another related to the risk of the internationally active banking sector, and the third is an unobservable systematic factor. Default probabilities, inferred from a tractable reduced form model for CDS spreads, are compared with expected default frequencies from the Moody’s KMV model. The results lend empirical support to the hypothesis that structural models can be less informative than reduced-form models of CDS spreads in the case of banks with major investment banking activities as the leverage loses explanatory power. Although the CDS market appears to have matured over the observation period, during certain periods premiums for liquidity risk can increase substantially thus limiting the value of CDS spreads as market indicators. We conclude that equity prices and CDS premia should be considered together to fully exploit the information content of both market indicators and to mitigate their respective drawbacks.

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.     

Market‐based estimates of implicit government guarantees in European financial institutions

I exploit the price differential of credit default swap (CDS) contracts written on debts with different levels of seniority to measure the implicit government guarantees enjoyed by European financial institutions from 2005 to 2013. I determine that the aggregate guarantee increased substantially during the recent financial crises and peaked at an average of 89 bps in 2011. My analysis suggests that the extent of implicit support depends on the type of financial institutions and there exists a eurozone effect. Further investigation of feedback relationship shows that the guarantee implicitly offered by a government positively ‘Granger causes’ the sovereign's default risk.     

Credit derivatives and stock return synchronicity

The role of credit default swaps (CDS) in the 2008 financial crisis has been widely debated among regulators, investors, and researchers. While CDS were blamed for destabilizing the financial system, they remain effective tools for hedging credit risk, especially for major banks, and produce positive informational externalities to market participants. This paper examines whether the introduction of CDS enhances the amount of firm-specific information impounded in stock prices. We use stock return synchronicity to measure the amount of firm-specific information reflected in stock prices, with more firm-specific information being associated with a lower level of synchronicity. We find that a firm’s stock return synchronicity decreases after the commencement of CDS trading. This finding is robust to different model specifications, synchronicity measures, and endogeneity controlling methodologies. Furthermore, the decrease in stock return synchronicity is more pronounced for CDS firms with higher credit risk. Overall, our evidence supports the positive role of CDS in improving informativeness of stock prices.     

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.     

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.     

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.     

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.     

Endogenizing exogenous default barrier models: The MM algorithm

In this paper, we propose a Maximization–Maximization (MM) algorithm for the assessment of hidden parameters in structural credit risk models. Step M1 updates the value, volatility, and expected return on the firm’s assets by maximizing the log-likelihood function for the time series of equity prices; Step M2 updates the default barrier by maximizing the equity holders’ participation in the firm’s asset value. The main contribution of the method lies in the M2 step, which allows for ‘endogenizing’ the default barrier in light of actual data on equity prices. Using a large international sample of companies, we demonstrate that theoretical credit spreads based on the MM algorithm offer the lowest CDS pricing errors when compared to other, traditional default barrier specifications: smooth-pasting condition value, maximum likelihood estimate, KMV’s default point, and nominal debt.