Weight of the Default Component of CDS Spreads: Avoiding Procyclicality in Credit Loss Provisioning Framework

Abstract

The current expected loss calculations have recently attracted considerable attention in the research on credit risk modeling, impairment provisioning, and financial networks’ stability. A new CDS-based approach to estimate current expected credit loss is proposed for low default portfolios, containing credit exposures to corporate issuers covered by publicly traded CDS contracts. First, a fraction of CDS spread related to a pure default compensation for different CDS maturities is assessed. Our results contrast with previous research. Second, based on the obtained historical weights of the default risk premium, a forward-looking term structure of the probabilities of default implied by the current CDS quotes is derived. The proposed approach covers both investment and noninvestment grade debt. The resulting framework is applied to a sample of corporate bonds. The developed methodology provides a useful tool, on one hand, for credit risk managers and balance-sheet preparers and, on the other hand, for regulators of financial markets as it sheds light on how procyclicality could be avoided in provisions.

Excess liquidity premia of single-name CDS vs iTraxx/CDX spreads: 2007-2017

“…Our empirical study is in line with research focused primarily on the CDS market (Corò et al, 2013;Gehde-Trapp et al, 2015;Gubareva, 2019) and contributes to the existing literature on liquidity issues regarding CDS instruments. Thinking of the potential use of CDS spreads for forward-looking provisioning purposes, as in Gubareva (2019), it is important to study average levels of liquidity for long-run trough-the-cycle periods, as such an approach potentially allows eliminating procyclicality from risk parameters' estimations, as suggested in Borio (2018).…”

“…While quantifying credit risk, it may be necessary and/or useful to decompose the bond and CDS spreads into default and liquidity components and then use the default risk component for the calculation of probabilities of default to serve as inputs in the expected credit losses; see Huang and Huang (2012), Arakelyan and Serrano (2016), Gubareva (2019), among others. It is a hard task by itself as, for example, the default-and liquidity-risk impacts are hardly separable as they are observable jointly through CDS spread quotes.…”

“…Many other studies, such as Chen et al (2010), Lin et al (2011), Díaz et al (2013), Arakelyan (2014), Arakelyan et al (2015), Raunig (2015), Silva (2016), Hilscher and Wilson (2017), Kim (2017), Berndt et al (2018), Oh and Patton (2018), Gubareva (2019), and Wang et al (2019), focus on the CDS market-wide and firm-specific liquidity effects, spillovers of bond illiquidity to CDS premia, weights of the default and non-default components in CDS spreads, and diverse systemic risk subjects.…”

“…Second, almost all the studies dedicated to the CDS market liquidity, except those of Arakelyan and Serrano (2016) and Gubareva (2019), focus on the most liquid and most tradable maturity of CDS contracts equal to 5 years (5Y). Differently from the 5Y mainstream and in line with the two above cited studies, we cover several maturity points of the term structure, namely 1 year (1Y), 3 years (3Y), 5 years (5Y), 7 years (7Y), and 10 years (10Y), thus further advancing the frontier of the empirical research in the field of the CDS market liquidity studies, focused at term structure derivation.…”

The impact of Covid-19 on liquidity of emerging market bonds

“…As a by-product, from quantitative point of view, we find that five months average ratios ´bid/offer spread over OAS spread´ are 19% and 8% for IG and HY,reaching during the apogee of liquidity crisis 25% and 12%, respectively. It is an expected result as the weight of default component in credit spread is found to be lower for IG in comparison to HY (Gubareva, 2019). For HY, the difference in the bid/offer spread per issuer type is less pronounced than in the case of IG, perhaps meaning that the lower rating, the less attention market players pay to the sector of economic activity of the issuer.…”