Pricing default swaps: Empirical evidence

Houweling, Patrick; Vorst, Ton

doi:10.1016/j.jimonfin.2005.08.009

Cited by 241 publications

(119 citation statements)

References 37 publications

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“…Namely, both in academic studies and industry reports it has been common practice to fix corporate LGD at its historical average of 60% (cf. Houweling and Vorst (2005), Chen, Cheng, and Wu (2005), Longstaff, Mithal, and Neis (2005), Chen, Cheng, Cao, and Chen (1997) criterion our estimated risk premia imply reasonable risk preferences.…”

Section: Introductionmentioning

confidence: 66%

The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk

Schneider¹,

Sögner²,

Veža³

2010

J. Financ. Quant. Anal.

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A previous version of this paper was circulated as "Jumps and Recovery Rates Inferred from Corporate CDS Premia". We are thankful to FIRM@WU for access to their high-performance computing resources as well as friendly support, and to Dow Jones for providing us with complete ICB sector information. AbstractUsing an extensive cross-section of US corporate CDS this paper offers an economic understanding of implied loss given default (LGD) and jumps in default risk. We formulate and underpin empirical stylized facts about CDS spreads, which are then reproduced in our affine intensity-based jump-diffusion model. Implied LGD is well identified, with obligors possessing substantial tangible assets expected to recover more. Sudden increases in the default risk of investment-grade obligors are higher relative to speculative grade. The probability of structural migration to default is low for investment-grade and heavily regulated obligors because investors fear distress rather through rare but devastating events.

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Section: Introductionmentioning

confidence: 66%

The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk

Schneider¹,

Sögner²,

Veža³

2010

J. Financ. Quant. Anal.

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“…Historically, researchers often use Treasury yields to define the instantaneous interest rate and the benchmark yield curve. Houweling and Vorst (2003) perform daily calibration of reduced-form models using credit default swap spreads and find that eurodollar swap rates are better suited than the Treasury yields in defining the benchmark yield curve. Here, we define the benchmark instantaneous interest rate based on the eurodollar libor and swap rates.…”

Section: A Dynamic Term Structure Model Of Interest Rate Default Anmentioning

confidence: 99%

Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads

Chen

Cheng

2005

SSRN Journal

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Using a large data set on credit default swaps, we study how default risk interacts with interest-rate risk and liquidity risk to jointly determine the term structure of credit spreads. We classify the reference companies into two broad industry sectors, two broad credit rating classes, and two liquidity groups. We develop a class of dynamic term structure models that include (i) two benchmark interest-rate factors to capture the libor and swap rates term structure, (ii) two credit-risk factors to capture the credit swap spreads of high-liquidity group of each industry and rating class, and (iii) both an additional credit-risk factor and a liquidity-risk factor to capture the difference between the high-and low-liquidity groups.Estimation shows that companies in different industry and credit rating classes have different credit-risk dynamics. Nevertheless, in all cases, credit risks exhibit intricate dynamic interactions with the interestrate factors. Interest-rate factors both affect credit spreads simultaneously, and impact subsequent moves in the credit-risk factors. Within each industry and credit rating class, we also find that the average credit default swap spreads for the high-liquidity group are significantly higher than for the low-liquidity group. Estimation shows that the difference is driven by both credit risk and liquidity differences. The low-liquidity group has a lower default arrival rate and also a much heavier discounting induced by the liquidity risk.JEL CLASSIFICATION CODES: E43, G12, G13, C51.KEY WORDS: Credit default swap; credit risk; credit premium; term structure; interest rate risk; liquidity risk; liquidity premium; maximum likelihood estimation. Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap SpreadsIt is important to understand how credit risk interacts with interest-rate risk and liquidity risk in determining the term structure of credit spreads on different reference entities. Nevertheless, limited data availability has severely hindered the understanding. Since defaults are rare events that often lead to termination or restructuring of the underlying reference entity, researchers need to rely heavily on cross-sectional averages of different entities over a long history to obtain any reasonable estimates of statistical default probabilities.Although corporate bond prices contain useful information on the default probability and the price of credit risk, the information is often mingled with the pricing of the underlying interest-rate risk and other factors such as liquidity and tax. 1 The recent development in credit derivatives provides us with an excellent opportunity to better understand the pricing of credit risk, its interactions with interest-rate risk and liquidity, and the impacts on the term structure of credit spreads. The most widely traded credit derivative is in the form of credit default swap (CDS), written on a reference entity such as a sovereign country or a cor...

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“…The second method is to a priori fix a value. A number of researchers in the economic literature suggest that although the first method seems preferable, it turns out that it is hard to identify the recovery rate from the data, see Duffee (1999), Duffie and Singleton (1999) and Houweling and Vorst (2005). This may pose a problem for some applications; fortunately this does not affect the pricing of credit default swaps.…”

Section: B: Recovery Rate Estimatesmentioning

confidence: 99%

“…This may pose a problem for some applications; fortunately this does not affect the pricing of credit default swaps. Houweling and Vorst (2005) found that the pricing of default swap premium is relatively insensitive to the assumed recovery rate. As such this study assumes a constant recovery rate across the observation period.…”

Section: B: Recovery Rate Estimatesmentioning

confidence: 99%

“…An abundance of research has been devoted to default intensity dynamics unlike the dynamics of the recovery rate. This maybe partly due to the fact that as shown by Houweling and Vorst (2005) the recovery rate has negligible effects on the outcome of credit default swap prices. Generally, reduced form models assume an exogenous recovery rate that is independent of the probability of default.…”

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confidence: 99%

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US corporate default swap valuation: the market liquidity hypothesis and autonomous credit risk

Dunbar

2008

Quantitative Finance

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This paper develops a reduced form three-factor model which includes a liquidity proxy of market conditions which is then used to provide implicit prices. The model prices are then compared with observed market prices of credit default swaps to determine if swap rates adequately reflect market risks. The findings of the analysis illustrate the importance of liquidity in the valuation process. Moreover, market liquidity, a measure of investors' willingness to commit resources in the credit default swap (CDS) market, was also found to improve the valuation of investors' autonomous credit risk. Thus a failure to include a liquidity proxy could underestimate the implied autonomous credit risk. Autonomous credit risk is defined as the fractional credit risk which does not vary with changes in market risk and liquidity conditions.Credit default swaps, Market liquidity, Bid-ask spreads, Autonomous credit risk, Risk premium,

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Pricing default swaps: Empirical evidence

Cited by 241 publications

References 37 publications

The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk

The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk

Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads

US corporate default swap valuation: the market liquidity hypothesis and autonomous credit risk

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