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Exploring the components of credit risk in credit default swaps
Authors:Frank J Fabozzi  Xiaolin Cheng  Ren-Raw Chen
Institution:aSchool of Management, Yale University, 135 Prospect Avenue, New Haven, CT 06520, USA;bMoody's Investor Service, 99 Church Street, New York, NY 10007, USA;cRutgers Business School, Rutgers University, New Brunswick, NJ 08903, USA
Abstract: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.
Keywords:Credit default swap  Credit risk  Credit default swap spread  Bond spreads
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