An empirical analysis of the dynamic relationship between investment grade bonds and credit default swaps
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1 An empirical analysis of the dynamic relationship between investment grade bonds and credit default swaps Roberto Blanco, Simon Brennan and Ian W. Marsh
2 Credit derivatives Financial instruments that can be used to transfer credit risk Introduced in 1992, but only significant volumes since Exponential growth since then Single-name CDS are the most liquid
3 Credit Default Swaps Underlying asset: loan or bond issued by a reference entity Two players Buyer of protection makes period payments (premium) until occurrence of credit event or maturity Seller of protection compensates the buyer for the loss incurred as a result of a credit event (difference between par value underlying asset and market value)
4 Credit Default Swaps Credit events (ISDA 1999): Bankruptcy Failure to pay (Modified) Restructuring Physical settlement: repayment at par against delivery of underlying asset In practice, any bond or loan issued by the reference entity is deliverable (the buyer has a delivery option)
5 CDS versus bonds CDS BONDS Credit risk YES YES Funded NO YES Constant maturity YES NO Always par value YES NO Short selling constraints NO SOMETIMES Counterparty risk YES NO Delivery option YES NO
6 The price of risk Ignoring delivery option and repo specials By arbitrage, bond spread and the CDS price should be (approximately) equal, less accurate if steeply sloping term structure Non-par bonds But, Delivery option and/or repo specials imply CDS>CS
7 Aims and objectives Do bond and credit derivatives markets price risk equally? Which market reacts to information first? Do bond and credit derivatives markets price risk correctly?
8 Credit default swap data Five year CDS indicative prices for notional $10 million, ISDA benchmark contracts From CreditTrade and JP Morgan Daily data from January 2001 through June 2002 (Enron, 9/11, Worldcom etc) Bid-ask spreads from CreditTrade, midpoint only from JP Morgan
9 Bond data Bloomberg generic prices The most liquid near-par fixed coupon bonds with no embedded options, no stepup clauses or anything strange 2 bonds per issuer with maturities spanning 5 years linear interpolation gives 5 year yield
10 Sample 33 companies (16 US and 17 Europe) 11 US financial institutions 5 US corporates 6 European telecom companies 11 other European corporates/financials Ratings: AAA to BBB
11 Pricing errors What reference rate - Treasuries or swap rates? Basis = CDS price - (Bond yield - Ref. rate)
12 Pricing errors Evidence suggests swap rate is best Size of the basis? Relatively small, on average (15 bp) CDS and bonds price risk equally For some reference entities the basis (especially European companies) is too large
13 Pricing errors PRICING DISCREPANCIES BY RATING basis points AAA-AA A BBB BASIS ABSOLUTE BASIS
14 Pricing errors PRICING DISCREPANCIES BY REGION basis points US EUROPE BASIS ABSOLUTE BASIS
15 Pricing errors - same pricing CDS price vs credit spread. AOL /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/ /06/2002 basis points CDS CREDIT SPREAD
16 Pricing errors - same pricing CDS price vs credit spread. FORD /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/2002 basis points CDS CREDIT SPREAD
17 Pricing errors - different pricing CDS price vs credit spread. FRANCE TELECOM /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/ /06/2002 basis points CDS CREDIT SPREAD
18 Pricing errors -different pricing CDS price vs credit spread. FIAT /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/ /06/2002 basis points CDS CREDIT SPREAD
19 Pricing errors - explanation Limits to arbitrage (short-selling constraints) Delivery option on CDS prices Non-par bonds Higher pricing errors in Europe due to: Short-selling constraints Restructuring definition
20 Information discovery In most cases the two markets price equally on average But which one informs us of credit deterioration first? Where does the information discovery take place?
21 Discovery methods If CS and CDS price are cointegrated Hasbrouck Gonzalo-Granger Both based on estimated VECM If CS and CDS price diverge over time Granger causality
22 Price discovery Hasbrouck method suggests in 24/27 cases, >50% of discovery takes place in CDS market Gonzalo-Granger method suggests in 26/27 cases majority of discovery takes place in CDS market Granger causality suggests in 2/6 cases CDS lead, 2/6 neither lead and 2/6 bond and CDS influence each other
23 Determinants of price changes Regress changes in CDS & CS on changes: Macro factors: risk-free interest rate yield curve slope market risks: stock market volatility Equity market return (business climate) Micro factors: equity price specific stock volatility
24 Determinants of price changes Adjusted R 2 by models CDS MARKET CASH MARKET (1) Individual regr., fund. variables (2) (1) plus liquidity and lagged basis (3) Pool, fund. variables (4) (3) plus lagged basis (5) (3) with interactions (6) (4) with interactions
25 Determinants of price changes CDS MARKET CASH MARKET coefficient t-statistic coefficient t-statistic 2 YEAR INTEREST RATE CDS(-1)*LONG TERM INT RATE FIRM EQUITY RETURN CDS(-1)*FIRM EQUITY RETURN CDS(-1)*FIRM EQUITY VOLATILITY/ LIQUIDITY ERROR CORRECTION ADJUSTED R
26 Bottom lines Do bond and credit derivatives markets provide the same information? YES USUALLY WHEN REFERENCE RATE IS PROXIED BY SWAP RATE IF NOT THE PROBLEM SEEMS TO BE SHORT SALES CONSTRAINTS IN CASH MARKET CTD OPTION IN THE CDS MARKET
27 Bottom lines Which market reacts to information first? CDS PRICES APPEAR TO LEAD, AND BY A SIGNIFICANT LENGTH OF TIME
28 Bottom lines Do bond and credit derivatives markets price risk correctly? WE STILL DON T KNOW, BUT IN THE SHORT TERM CDS APPEAR TO REACT MORE SIGNIFICANTLY TO (FINANCIAL) VARIABLES WE THINK ARE RELATED TO DEFAULT
29 Implications CDS are cleaner and easier to use They appear to better reflect credit deterioration in the short-term And in most cases to be equivalent to bond spreads in the long-run But, in some cases, persistent discrepancies CDS prices are a useful source of information on corporate distress, but care must be taken in the presence of valuable CTD options (especially in the case of European companies)
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