Warren Buffet, the world’s richest man, once said that derivatives are financial “weapons
of mass destruction.” a term popularized by George W. Bush to describe nuclear arms.
Indeed financial derivatives have a far greater impact on the market than their underlying
due to their leverage effect. And the most popular and important credit derivatives
nowadays are credit default swaps with a current notional value of over 60 trillion US
dollars according to ISDA 1 (International Swaps and Derivatives Association) and 58
trillion US dollars according to BIS 2 (Bank for international settlement) respectively. That
is more than the whole world’s gross domestic product in the same year! 3
This paper examines the empirical relationship of CDS premium and credit spread by
testing on their theoretical equivalence derived by Duffie (1999). It begins with an
overview of CDS followed by the theoretical framework. The analysis starts with
explanation of testing methods and description of data. After confirming the existence of
the basis spread, this paper goes on to analyse the interactions of CDS spread and Bond
spread using econometrics methods like Cointegration and Granger Causality tests. Also
examined is the leadership of price discovery process between CDS market and traditional
bond market.
Table of Contents
1. The overview of credit default swaps
1.1 The development of credit default swaps
1.2 Structure of Credit Default Swaps
1.3 Regulation of CDS
1.4 Participants and usage of CDS
2. Theoretical framework
2.1 valuation of credit default swap
2.2. No-arbitrage approach
2.3 Equivalence relationship between CDS spread and bond spread
2.4 Methods of econometrics for the analysis
3. Explaining the data
3.2 Bond Data selection criteria
3.3 Risk free interest rates selection criteria
4. Empirical analysis
4.1 Basis spread
4.1.1 Average basis spread
4.1.2 Factors of the basis spread
4.1.3 Test on the existence of basis
4.2 Long-term relationship between the spread on both markets
5. Concluding comments
Objectives and Core Topics
This paper aims to empirically examine the relationship between Credit Default Swap (CDS) premiums and traditional credit spreads by testing their theoretical equivalence. It investigates whether CDS markets and bond markets are cointegrated and explores the short-term causal interactions and price discovery leadership between these two market segments.
- Theoretical and empirical analysis of the relationship between CDS spreads and bond spreads.
- Testing for the existence of "basis spread" discrepancies in market data.
- Application of econometric methods, specifically Augmented Dickey-Fuller tests and Cointegration models.
- Investigation of price discovery leadership using Granger Causality tests.
Excerpt from the Book
1.2 Structure of Credit Default Swaps
A credit default swap is in simple terms a contract between two counterparties trading on credit risk of a third party. It is to some extent similar to an insurance contract, with one party selling the protection against credit risk for a certain premium, and the other party paying the price for protection and thus receiving a payoff if a third party defaults. The third party here is referred to as the reference entity. The typical maturity of credit default swaps is 5 years, although 3, 7, and 10 year contracts are also traded. Theoretically it could be any other length of time.
The buyer of a CDS pays a periodical premium on an underlying e.g. Bonds, for a certain period of time in exchange for a payment in case of credit event. If the company which issued the bonds defaults within the runtime of the CDS contract, the seller pays the buyer the settlement as initially arranged. There are two types of settlement: physical settlement and cash settlement. When the physical settlement is chosen, which is still more often the case though its usage is declining; the buyer delivers the defaulted bonds to the seller and receives from him its par value. The CDS buyer does not need to be in possession of the bonds upon entering the contract and only has to acquire them, when it comes to physical settlement. If the cash settlement is required, the seller pays the buyer the difference between the par value and the recovery amount of the defaulted bonds, and no delivery of any bonds is needed.
Summary of Chapters
1. The overview of credit default swaps: Provides a comprehensive introduction to the history, structure, and market participants of CDS.
2. Theoretical framework: Outlines valuation models, specifically the no-arbitrage approach, and defines the econometric methodologies used for analysis.
3. Explaining the data: Describes the selection criteria for CDS and bond data, including the use of Bloomberg data and the filtering of reference entities.
4. Empirical analysis: Presents the findings regarding the basis spread, long-term cointegration, and short-term Granger causality between CDS and bond markets.
5. Concluding comments: Summarizes the key results, confirming that CDS markets generally lead bond markets in the price discovery process.
Keywords
Credit Default Swaps, CDS, Bond Spread, Basis Spread, Cointegration, Granger Causality, Price Discovery, No-Arbitrage, Market Liquidity, Risk Management, Econometrics, Financial Derivatives, Investment-Grade, Default Risk, Reference Entity
Frequently Asked Questions
What is the primary focus of this research?
The research focuses on the empirical relationship between CDS premiums and credit spreads, evaluating their theoretical equivalence and how they interact in the financial market.
What are the central themes of the work?
The central themes include the valuation of CDS, the identification of basis spreads, and the analysis of market integration and price leadership between CDS and bond markets.
What is the main research objective?
The objective is to determine if CDS and bond spreads move together in the long run and to understand which market leads the other in processing information related to credit risk.
Which scientific methods are employed?
The study utilizes time series analysis, specifically Augmented Dickey-Fuller tests for stationarity, Cointegration tests, and Granger Causality tests for short-term interaction dynamics.
What is covered in the main part of the paper?
The main part covers the theoretical foundation, a detailed explanation of the data selection process (including reference entities), and an empirical analysis involving various statistical tests on basis spreads and causality.
Which keywords best characterize this research?
Key terms include Credit Default Swaps, basis spread, cointegration, Granger causality, and price discovery in financial markets.
How is the "basis spread" defined in this study?
The basis spread is defined as the difference between the CDS spread and the credit spread of the underlying bond.
What conclusion does the author draw regarding price leadership?
The author concludes that there is strong evidence that the CDS market leads the bond market in the price discovery process due to faster processing of market information.
- Quote paper
- Ralf Koschmieder (Author), Furong Liang (Author), 2010, The empirical relationship between the spreads of Credit Default Swaps and Bonds, Munich, GRIN Verlag, https://www.grin.com/document/149685
