Credit risk signals in CDS market vs agency ratings

Abstract

Purpose-This research aims to model the relationship between the credit risk signals in the credit default swap (CDS) market and agency credit ratings, and determines the factors that help explain the variation in such signals. Design/methodology/approach-A comprehensive analysis of the differences in the relative credit risk assessments of CDS-based risk signals and agency ratings is provided. It is shown that the divergence between credit risk signals in the CDS market and agency ratings is explained by factors which the rating agencies may consider differently than credit market participants. Findings-The results suggest that agency credit ratings of relative riskiness of a reference entity do not always correspond with assessments by CDS spreads, as the price of risk is a function of additional macro and micro factors that can be explained using statistical analysis. Originality/value-This research is unique in modeling the relationship between the credit risk assessments of the CDS market and the agency ratings, which to the best of the authors' knowledge has not been analyzed before in terms of their agreement and the level of discrepancy between them. This model can be used by investors in debt instruments that are not explicitly CDSs or which have illiquid CDS contracts, to replicate market-based, point-in-time credit risk signals. Based on both market-based and firm-specific factors in this model, the results can be used to augment through-the-cycle credit risk assessments, analyze issues surrounding the pricing of CDSs and examine the policies of credit rating agencies.

Bank systemic risk: An analysis of the sovereign rating ceiling policy and rating downgrades

“…Additionally, we also examine the bond yields of banks around the sovereign downgrade event. This is important because in some cases the expectations of a bank's risks can be different to that signaled by the bank's credit rating outlook (Finnerty et al., 2013; Jacobs et al., 2016). Therefore, we first focus on the Eurobond yields since we rely on the S&P foreign currency issuer ratings of our banks.…”

Managerial tone and investors' hedging activities: Evidence from credit default swaps

“…Our focus is CDS trading position, which is conceptually different from the CDS price (i.e., CDS spread). Specifically, CDS positions capture the actual amount of credit risk transferred via the CDS market (Oehmke & Zawadowski, 2017), while CDS spread theoretically represents the amount of compensation demanded for taking on the credit risk of the underlying reference entity (Jacobs et al, 2010). Moreover, CDS spread does not represent pure credit risk in practice (Jacobs et al, 2010).…”

“…Specifically, CDS positions capture the actual amount of credit risk transferred via the CDS market (Oehmke & Zawadowski, 2017), while CDS spread theoretically represents the amount of compensation demanded for taking on the credit risk of the underlying reference entity (Jacobs et al, 2010). Moreover, CDS spread does not represent pure credit risk in practice (Jacobs et al, 2010). It is a function of both macro and micro factors, such as the equity market's implied volatility, the risk-free rate and liquidity of the CDS contract.…”

CDS-based implied probability of default estimation

“…This probability can be deduced from the market data, or from the historical data provided by the rating agencies (Merton, 1974;Jarrow, 2001;Hull et al, 2004). Some studies showed that credit default swaps (CDS) spreads reflect information more precisely than credit rating and showed the effectiveness of the CDS spread in the prediction of credit risk and that the default probability withdrawn from the CDS spread is more real than the probability of default withdrawn from other market data (Flannery et al, 2010;Dwyer et al, 2010;Cizel, 2013;Jacobs et al, 2016;Rodriguez et al (2019).…”