This thesis investigates the default probabilities of market-implied sovereign default probabilities by using credit default swap (CDS) spreads and conducts an analysis of the spreads’ determinants. Building on the no-arbitrage pricing model of CDS, the probabilities for Greece defaulting within the next five years from today is approximately 75%, assuming a recovery rate of 25%. Against economical intuition, the results provide a positive correlation between the recovery rate and CDS spreads.
A comparison of Greece’s default in 2012 with its default probabilities indicates that spreads closer to 2012 are much higher, hence imply higher default probabilities and therefore capture the default accurately. Though, spreads taken exactly T years before the default provide vague, i.e. very low default probabilities.
The regression analysis provides different results for the determinants of spreads of either country, though in neither model all variables are statistically significant individually, e.g. Greece’s spreads can solely be explained by the country specific factor, the unemployment rate. The unexpected negative effects of FX on the spreads could be an indicator of a cracked Eurozone.
Further, the analysis of today’s actual vs. the regression’s predicted spread indicates an overestimation of the predicted spreads of Greece, Italy, Germany and France, where Greece’s absolute difference between the actual and predicted spread by far is the biggest (approx. 7000 BPS). Hence, Greece also seems to be very likely to default from statistical view. Assuming that the statistical model is correct and always overestimates the spreads by a factor of 4.4, then results suggest a potential statistical arbitrage possibility where the arbitrageur would go long in the French spreads and short in the German spreads.
Table of Contents
1 Introduction
1.1 Problem formulation
1.2 Delimitations
1.3 Methodology
2 Theory: Credit Default Swaps
2.1 The contract and its terms
2.2 Corporate vs. sovereign CDS
2.3 Inferring default probabilities from CDS spreads
2.3.1 Default probabilities and the hazard rate λ
2.3.2 The Arbitrage-free model
3 Application of market-implied default probabilities
3.1 Default probabilities in five years for European sovereigns
3.2 Historical defaults and market-implied default probabilities
4 Analysis of CDS spreads
4.1 Greece’s, Germany’s, France’s and Italy’s spread evolution
4.2 Determinants of sovereign CDS spreads
4.3 Global risk factors
4.3.1 Stock market volatility index: VIX
4.3.2 The risk-free rate
4.3.3 Foreign Exchange rate, EUR/USD
4.4 Country specific factors
4.4.1 Local stock market
4.4.2 Domestic inflation rate
4.4.3 Unemployment Rate
4.5 Expected effects of explanatory variables on the spreads
5 Regression results
5.1 Greece’s CDS spread determinants
5.2 Germany’s CDS spread determinants
5.3 Italy’s CDS spread determinants
5.4 France’s CDS spread determinants
5.5 Predicted vs. actual spreads
6 Conclusion
7 Appendix
Research Objectives and Key Themes
This thesis aims to investigate market-implied sovereign default probabilities for selected European countries by utilizing Credit Default Swap (CDS) spreads. The research centers on the validity of these probabilities in predicting sovereign credit events and analyzes the macroeconomic determinants that drive CDS spread fluctuations through multiple linear regression.
- Computation of CDS-implied default probabilities for European sovereigns.
- Empirical comparison of market-implied probabilities with historical credit events (specifically the 2012 Greek default).
- Identification of global financial risk factors influencing CDS spreads (e.g., VIX, risk-free rate, FX rates).
- Analysis of country-specific determinants of spread volatility (e.g., local stock markets, inflation, unemployment).
- Validation of regression models by comparing predicted spreads with actual market data.
Excerpt from the Book
2.1 The contract and its terms
A CDS is a type of credit derivative, whose payoff depends on the whether a third party, i.e. either a company (for corporate CDS) or a country (for sovereign CDS), defaults or not. It is a contract between a default protection buyer and a default protection seller to provide insurance against the risk of default by a third party, the so-called reference entity. The reference entity however, is not part of the contract. The contract gives protection until some specified maturity date T or until default, whichever occurs first. It also specifies the time for the periodic payments of the buyer, which usually are made in arrears quarterly. The buyer of the contract takes a long position in the contract, whereas the protection seller takes the corresponding short position. The buyer owns one or more assets of the reference entity, so the buyer has an exposure to these assets of the reference entity. In return to the insurance against the credit risk, which the protection buyer receives, the protection buyer makes the periodic payments, which is known as the premium leg, until the end of the contract or until a default occurs – whichever event occurs first, will stop the payments and the contract will cease (Hull, 2012, pp. 547-548).
The payment of the protection seller to the protection buyer to compensate for the loss in case of default is called the protection leg. The protection leg is equal to the difference between par and the price of the cheapest to deliver asset of the reference entity on the face value of the protection (O’Kane and Turnbull, 2003, p. 3).
Summary of Chapters
1 Introduction: Provides an overview of the financial landscape post-Lehman Brothers, defines the purpose of using CDS for sovereign risk, and outlines the thesis methodology.
2 Theory: Credit Default Swaps: Explains the foundational mechanics of CDS contracts, differentiates between corporate and sovereign instruments, and develops the no-arbitrage model to infer hazard rates and default probabilities.
3 Application of market-implied default probabilities: Applies the theoretical model to compute default probabilities for European sovereigns and evaluates their accuracy by comparing them to historical defaults.
4 Analysis of CDS spreads: Examines the evolution of CDS spreads for Greece, Germany, France, and Italy, and identifies global and local macroeconomic factors that serve as potential determinants.
5 Regression results: Presents the findings of multiple linear regressions for each country and evaluates the model's performance in predicting current spreads.
6 Conclusion: Summarizes the thesis findings, confirming that while CDS spreads reflect default risk, they are subject to limitations regarding recovery rate assumptions and macroeconomic influences.
7 Appendix: Contains supporting statistical tables, supplementary probability calculations, and historical data proofs for the regression analysis.
Keywords
Credit Default Swap, Sovereign Default, Default Probability, Hazard Rate, No-Arbitrage Pricing, CDS Spreads, Macroeconomic Determinants, Regression Analysis, Eurozone Crisis, Credit Risk, Recovery Rate, Financial Markets, Sovereign Debt, Risk-Neutral Measure, Market-Implied Probability.
Frequently Asked Questions
What is the core focus of this thesis?
The thesis investigates how sovereign default probabilities can be derived from Credit Default Swap (CDS) spreads and what macroeconomic factors determine the fluctuations of these spreads.
What are the primary themes examined?
The work covers theoretical CDS pricing, the application of these models to European sovereign data, the influence of global risk factors like market volatility, and country-specific economic indicators.
What is the main objective or research question?
The primary objective is to compute market-implied default probabilities and determine if current regression models accurately predict sovereign defaults based on observed market spreads.
Which scientific methods are employed?
The research uses the no-arbitrage pricing model for CDS valuation and applies multiple linear regression analysis to identify significant determinants of spread changes.
What does the main body cover?
It details the contractual nature of CDS, derives hazard rates, performs empirical tests comparing market spreads to actual credit events, and presents regression results for Greece, Germany, Italy, and France.
Which keywords best characterize this research?
Key terms include Credit Default Swaps, sovereign risk, market-implied default probabilities, hazard rates, and macroeconomic determinants.
Why is the 2012 Greek default significant in this study?
The 2012 default serves as a critical real-world test case to evaluate how effectively CDS spreads predicted a sovereign credit event prior to its occurrence.
How does the assumption of the recovery rate impact the results?
The study finds that the recovery rate is a decisive variable; adjusting it significantly changes the output of default probabilities, highlighting its crucial role in the accuracy of the no-arbitrage model.
What does the comparison between predicted and actual spreads reveal?
The analysis indicates that the regression models consistently overestimate spreads across the sampled countries, suggesting potential limitations in the model's assumptions or the impact of market volatility.
- Arbeit zitieren
- Charlotte Klausen (Autor:in), 2015, Investigation of the Market-Implied Sovereign Default Probabilities, München, GRIN Verlag, https://www.grin.com/document/369427
